Two U.S. investment titans are clashing over whether public pensions should be protected in municipal bankruptcy, a major test that has implications for workers, investors and distressed cities across the country.

Payments into pension funds are usually considered sacrosanct, but fights are breaking out around the U.S. over who gets priority when a municipality seeks protection from creditors. The latest battle involves the bankruptcy of Stockton, Calif., and pits mutual-fund giant Franklin Templeton Investments against California Public Employees' Retirement System, the largest public pension fund in the U.S.

The firms disagree on whether Stockton's retirement contributions should be reduced to free up money for a loan repayment. U.S. Bankruptcy Court Judge Christopher Klein in Sacramento could rule on the dispute as early as Tuesday.

Many troubled municipalities are grappling with how to bring down pension costs while municipal-bond holders are trying to figure out how to protect their interests before or during a municipal insolvency. Franklin Templeton is separately challenging a new law in Puerto Rico allowing some troubled public agencies to restructure their debt, saying it violates the U.S. Constitution.

A ruling that Stockton's pensions can be curtailed could embolden more cities to use bankruptcy as a way to seek retirement concessions. In December the judge overseeing Detroit's bankruptcy case ruled that pensions aren't entitled to "extraordinary protection" despite state constitutional safeguards against benefit cuts. Calpers has argued in court that the ruling on Detroit's city-run retirement systems doesn't apply to California's state-run plan.

The outcome in Stockton "is being watched by everyone," said Suzanne Kelly, co-founder of Scottsdale, Ariz., pension strategy and restructuring firm Kelly Garfinkle Strategic Restructuring LLC. If the judge rules that pensions can be curtailed, Ms. Kelly added, it could push cities "on the brink" to see bankruptcy as a "feasible option."

Franklin Templeton, which manages assets of more than $908 billion, is the lone creditor challenging Stockton's plan to end a two-year run through bankruptcy, arguing the northern California port city wants to unfairly slice a debt repayment while leaving public pension contributions intact. The city is offering the San Mateo, Calif., firm about $350,000, or less than 1%, back on a $35 million loan that paid for fire stations, a police station, bridges, street improvements and parks.

"The meager recovery that the city is attempting to cram down," said a Franklin Templeton spokeswoman, "has left us with no choice but to object so that we can deliver a fair recovery for our investors."

The state's retirement system, known by the acronym Calpers, has responded by arguing pension payments are guaranteed by California law and can't be cut. Stockton contributes roughly $30 million a year to Calpers, which controls retirement money for municipal workers across California and has assets of roughly $300 billion.

A Calpers actuary testified in May that Stockton would be faced with a hefty fee if it chose to terminate its relationship with the retirement system. The amount would be $1.6 billion, according to Calpers. "How will that get Franklin more money?" said John Knox, an attorney representing the city of Stockton. "It boggles the mind."

The bankruptcy judge is expected to rule on the value of the collateral supporting Franklin Templeton's $35 million loan: two golf courses and a park. It isn't known if he also will rule on the larger question of whether pensions can be reduced.

Stockton, with a population of roughly 300,000, needs the judge to approve its plan to repay creditors before it can exit from bankruptcy. It filed in June 2012 after taking on too much debt and losing tax revenue to the real-estate bust. It was the second-largest financial failure by a U.S. city and one of several California cities—San Bernardino, Vallejo and Mammoth Lakes— to seek bankruptcy protection in recent years.

The judge in Stockton, California's bankruptcy on Tuesday ruled that the city has collateral worth $4 million with which it could pay holdout creditor Franklin Templeton, dismissing the city's contention its collateral was worthless.

At the same time, U.S. Bankruptcy Judge Christopher Klein made no ruling on Tuesday on whether the California Public Employees' Retirement System, or Calpers, should be made to accept less than the entire amount it is owed while bondholders take losses in the case.

Klein's ruling on the collateral in the case of Stockton, which filed for bankruptcy in June 2012, followed a trial that concluded last month and centered around Franklin's objection to the city proposing to repay it less than a penny on the dollar for a debt of about $36 million.

The city's collateral against bonds held by Franklin includes two golf courses, a community center and a park, which the city had estimated had no value while Franklin had pegged their value at $6.12 million to $17.34 million.

"Of course one of the problems with appraisals is everyone comes in with an appraisal that supports their position," Klein said from the bench on Tuesday. "Judges have long figured out that they need to be skeptical with their opinions."

Klein challenged Calpers, Stockton and its public employees to counter his reading of the California Public Employees' Retirement Law, which he understood to spell out that Calpers itself could not be impaired in bankruptcy but employees' pensions could be.

"It seems to me if you're going to take away part of an individual's pension, the individual employee is the creditor and Calpers is in effect a servicing agency," said Klein. "It looks to me like Calpers does not bear the financial risk of a shortfall in payments. Instead the structure of the (law) places that risk on the employee."

Klein questioned a $1.6 billion termination fee that Calpers has said it could impose on Stockton if the city ended its contract with the $285.2 billion pension fund.

"It really makes me wonder whether this so-called lien is the kind of thing that could be enforced," said Klein. "I'm going to need some explanation about why I should take that lien seriously."

The question of how Calpers, the largest U.S. pension fund, should be treated is of keen interest for investors and bond issuers in the $3.7 trillion U.S. municipal bond market.

The treatment of pension systems has been uneven in the handful of recent municipal bankruptcy cases.

In the case of Detroit, the largest-ever Chapter 9 insolvency case that will go to trial later this summer, the city has proposed that city pension funds share some of the loss.

But in Vallejo, California, which emerged from bankruptcy in 2011, Calpers was left whole.

The next hearing is scheduled for Oct. 1.

Federal Judge Christopher Klein will not rule on Stockton's bankruptcy exit plan until at least October as he continues scrutinizing California's public-employee pension system, but he did make a determination Tuesday that rendered city-owned recreational facilities safe from creditors.

During a 150-minute court session that ended a five-week hiatus in the bankruptcy trial, Klein said he may rule on Stockton's plan on Oct. 1. If he approves the plan, the city will emerge from bankruptcy after 27 months.

But between now and October, Klein said he wants the city to provide "a somewhat more focused analysis" of why he should confirm its proposal, called a plan of adjustment.

The judge said he continues to contemplate Stockton's decision to craft a plan that does not call for a reduction of the city's financial obligations to the California Public Employees' Retirement System.

Had Stockton sought to terminate its CalPERS contract, though, it could have cost the city in excess of $1.5 billion - more than double its annual budget.

Klein said Tuesday he "might very well conclude the CalPERS contract would be rejected and that the $1.5 billion lien is not enforceable." He added, "but that does not necessarily mean this plan of adjustment is not necessarily confirmable. It might be perfectly well confirmable."

Stockton's lead bankruptcy attorney, Marc Levinson, said Klein "is thinking about it. I don't believe he's made up his mind. He's asking counsel to give input. This is a judge who loves input."

Spokesman Brad Pacheco issued a statement on behalf of CalPERS.

"In fulfillment of our fiduciary duty, CalPERS will continue to protect the benefits promised to our members," he said.

"We welcome the opportunity to respond to the questions Judge Klein raised in court (Tuesday), to discuss the implications of the California laws that govern pensions and that create a stable retirement system that provides significant value to cities and their employees."

Former Stockton City Manager Dwane Milnes, who heads a group of retirees that formed as a result of the city's bankruptcy, said he heard nothing from Klein that the judge hadn't previously said.

"Nobody should be surprised by what he said," Milnes added. "What he said was consistent. He wants to be convinced."

Klein indicated his goal is to wrap up the case at the October hearing.

"Ideally I'd like to be able to make findings that would conclude the matter," he said.

The judge did make one ruling Tuesday of great significance to Stockton. Klein set the value of the collateral Stockton put up to secure a $35 million loan from Franklin Templeton Investments in 2009 at slightly more than $4 million.

Levinson said Stockton most likely will pay that amount to Franklin as a lump sum, though he indicated there is a chance the city will seek to pay over time. The attorney did say the city has ruled out turning over possession of the collateral to Franklin.

"It's a choice between cash, and cash over time, and I strongly suspect it will be the former," Levinson said.

Franklin's attorney, James Johnston, declined to comment on the judge's ruling. At stake in the decision were the city's hold on Oak Park (including its ice rink), as well as the Van Buskirk and Swenson golf courses. Franklin is the one bankruptcy creditor with which the city did not reach a pretrial settlement.

Months ago, a Franklin expert had assessed the value of the properties at just under $15 million if the investment giant took permanent possession of them. The city argued that the facilities have no value, mainly because they need millions of dollars in repairs and maintenance.

In the end, the judge set a value of $4,052,000, about 15 percent below what the Franklin expert had deemed as the properties' value if held until 2053.

As for his CalPERS remarks, Klein called his findings "preliminary" and said he is taking great care with a final decision because he doesn't want to make "a boneheaded mistake."

Levinson's team, as well as CalPERS attorneys, will work now to prepare briefs for the court that bolster their positions heading into October. Klein, meanwhile, has plenty of time to ponder the issue and said he still can be "persuaded" one way or the other.

"I've been sharing with you my thinking," he said toward the end of Tuesday's hearing. "I have not made any formal decisions."

The asset size of CalPERS, the largest defined benefit pension plan in the U.S., crossed the $300 billion mark for the first time.

California Public Employees’ Retirement System, Sacramento, reached $300.4 billion on Wednesday, spokesman Brad Pacheco said in an e-mailed statement.

Mr. Pacheco said in the statement that recent performance of the stock market has helped the pension fund achieve the milestone, but he also expressed caution about the future.

“While this is good news, there is still much more work to be done,” Mr. Pacheco said. “CalPERS has approximately 70% of the assets necessary to pay long-term retirement benefits. When our assets fell during the downturn, our pension liabilities never stopped accruing.”

CalPERS assets had reached $253 billion on Dec. 31, 2007, but one year later, assets had dropped by more than a quarter to $183.3 billion.

The Federal Thrift Savings Plan, Washington, is the only U.S. retirement plan with more assets than CalPERS; its defined contribution plans had combined total assets of $403 billion as of March 1.

Bill Ackman's Pershing Square has topped a list of the year’s best-performing hedge funds at a time when event-driven funds thrive while their trend-following rivals suffer.

Mr Ackman’s $5.8bn activist hedge fund Pershing Square International has returned 23.3 per cent to the end of June, according to data from HSBC’s Alternative Investment.

His fund is one of several event-driven strategies, which make bets around corporate events such as mergers and acquisitions, to feature in the top 20 best-performing funds of the year.

Global macro funds, by contrast, which trade instruments including currencies, interest rates and foreign exchange based on changes in economic policy, have dominated HSBC’s list of the worst-performing funds.

Event-driven funds have benefited from a rise in mergers and acquisitions and buyback activity, as well as low volatility and falling yields, according to Alex Allen, senior portfolio manager at Sciens Alternative Investments.

These conditions have led other event-driven strategies, including the Tyrus Capital Opportunities fund, the Trishield Special Situations fund and Mudrick Distressed Opportunity fund, to register gains of 18.1 per cent, 15.3 per cent and 15 per cent respectively.

The wider hedge fund industry, by contrast, is up 1.6 per cent year to date, according to Hedge Fund Research, the data provider.

At the other end of the performance scale, three macro funds, including Mellon Capital’s $871m Offshore Alpha Access fund, the $851m Rubicon Global fund and the $417m Eagle Global fund, are the worst performers year to date.

The Mellon fund was down 21.7 per cent to the end of May, while Rubicon and Eagle are down 17.8 per cent and 17.4 per cent respectively. The average macro hedge fund has returned 0.7 per cent year to date, according to HFR.

Amy Bensted, head of hedge fund products at Preqin, the data provider, said: “There has been lots of pressure on [macro funds] as markets have been difficult to follow and lots of big funds have made losses. This is a continuation of a trend – [macro funds] have been at the bottom of our performance benchmarks and they have struggled to generate returns from any major themes in the last few years.”

Ms Bensted added, however, that the poor performance figures have not led to significant outflows for the larger macro managers as nervousness builds about the resilience of equity markets.

She said: “Macro has popped into second position in terms of the most searched for strategy as investors look for non-correlation to equity markets.”

Mr Allen added: “Absolute correlation between hedge fund strategies is on the rise and is high by historical standards. Where you have high correlations, it implies a lack of diversification. Macro is one of the areas you still get that diversification benefit.”

Speaking up is paying off.

Activists are once again at the top of the hedge-fund heap, after a profitable stretch of clashes with companies around the world.

Activist managers gained 6.5% in the first half of the year, almost double the total for the average hedge fund, according to data to be released this week by research firm eVestment. Activist investing, in which managers buy stakes in companies and then agitate for changes in the form of buybacks, divestitures or management shakeups, was also the top-performing strategy among hedge funds in 2013.

The fund managers could earn millions for themselves—and billions for their investors—if the gains stick through the end of the year.

But with deal making near its historical peak, some investors and analysts wonder if the activist rally could start to sputter.

William Ackman, founder of Pershing Square Capital Management LP, is likely the biggest winner among the larger firms this year. His main fund posted a 25% gain in the first half, investor documents show, likely earning his firm fees estimated at nearly $1 billion so far in 2014.

Mr. Ackman has profited from his unusual backing of Valeant Pharmaceuticals International Inc.'s bid for Botox maker Allergan Inc., as well as a recent decline in the price of Herbalife Ltd., the nutritional-supplements maker he is betting against. Allergan traded at $116 a share before Pershing Square began rapidly building its stake in April. Shares closed Monday at $165.85, or 51% higher. Herbalife, which closed Monday at $66.18, is down 16% this year.

Mr. Ackman has long been known for his large, concentrated public bets. But this latest rise of shareholder activism, which was earlier known by less-flattering terms like corporate raiding, is creating new standouts.

Keith Meister spent most of his career as a little-known deputy of Carl Icahn before striking out on his own three years ago to start Corvex Management LP in New York. Since the start of last year, Corvex has more than tripled in size to manage more than $7 billion.

Its main fund is up nearly 11% this year, a person familiar with it said, helped by the resolution of Corvex's battle against CommonWealth REIT CWH +1.78% and the purchase of jeweler Zale Corp. by Signet Jewelers Ltd. SIG -1.75% , a large Corvex holding.

Despite the strong first half from activists, they still trailed the broader stock market: The S&P 500 rose 7.1% in the first half, including dividends.

Hedge funds as a whole gained about 3.1% in the first half, though most managers profess not to measure themselves against the broader stock market, because they aspire to do well in both rising and falling markets, and because they also invest in areas outside equities.

Bolstered by wealthy investors eager to profit from corporate changes, activist managers continue to engorge with cash—they attracted some $4 billion of new allocations in May alone, eVestment said.

"It's not just the money that's gone in, but the world is more supportive of what they are doing," said Justin Sheperd, chief investment officer at Chicago-based Aurora Investment Management LLC, which puts more than $9 billion into hedge funds. "It's a different environment today."

Activists also are increasingly busy. According to FactSet SharkWatch, there were 148 activist campaigns launched in the first half of this year, the most since the financial crisis.

The tide could yet turn if stock markets stumble. Many activists, as well as others who bet on company changes, lost money in the second half of 2011, when economic uncertainty put the brakes on mergers activity.

Mr. Sheperd said he was optimistic for the back half of the year, as long as interest rates remain low, encouraging mergers and acquisitions. However, he said if markets go "haywire," then activists could do the same.

There are some indications that the great swelling of many activist firms, which has given them broader heft to agitate for corporate changes, may be on the ebb. Jana Partners LLC, a New York activist firm that rose past $10 billion under management this year, closed its largest fund to new investment in the spring so it could better manage the growing size, according to investor communications.

Jana, which gained 8% in that fund in the first half, also is weighing shutting off fundraising at its other fund in the near future, a person familiar with the firm said.

Several investors cited Jana founder Barry Rosenstein's reported purchase this spring of the most expensive home in the U.S., a $147 million beachfront mansion in the Hamptons, as a reminder of past market peaks.

Mr. Ackman, whose Pershing Square manages more now than it ever has before, has actually seen more money leave than come in this year, documents show, as some investors take money off the table.

Investors have pulled more than $400 million from Pershing Square over the past six months, though that sum represents less than 3% of the firm's capital.

Other well-known activists also posted solid starts in 2014, as Daniel Loeb's $15 billion Third Point LLC and Trian Partners LP, part of the $9 billion firm co-founded by Nelson Peltz, each returned about 6%.

It also has been a long wait for one big-name hedge fund that has increasingly dabbled in activism in recent years.

Paul Singer's Elliott Management Corp. is sitting on defaulted Argentine bonds and related claims valued at as much as $2.5 billion, or 10% of the firm's total assets under management.

As Mr. Singer and Argentine officials tussle publicly over the repayment of the bonds, however, the New York-based firm's Elliott International Ltd. fund is lagging behind its peers. It is up just 4.1% in the first half of 2014, an investor update shows.

Billionaire hedge fund manager Ray Dalio is the king of the rich hedge fund industry. He runs the biggest hedge fund outfit in the world, Bridgewater Associates, a firm with $150 billion under management that Dalio founded in 1975. So far, Dalio’s having a pretty good 2014 following a challenging two-year stretch.

Dalio’s key All Weather Fund has returned 11.16% this year through June, according to an investment report reviewed by Forbes. The Standard & Poor’s 500 index returned 6.05% over the same time period. The All Weather fund is up 17.01% in the last 12 months.

Things are looking sunnier for Dalio. The good performance of All Weather is an important reversal for him and Bridgewater. With more than $70 billion in assets, the All Weather fund is built around a risk-parity strategy that Dalio has helped popularize. The strategy, which leverages up bond investments in an attempt to balance out portfolios, is supposed to generate good performance in just about any market environment. But last year All Weather was down by about 4% as the U.S. stock market soared by more than 30%. The All Weather Fund’s loss in 2013 hurt Dalio’s reputation as a guy who could consistently deliver steady returns for institutional investors, particularly pension funds.

Bridgewater’s big Pure Alpha hedge fund returned 7.77% in the first six months of the year. That not only beats the U.S. stock market, it bests the average hedge fund manager, who has only been able to return 3.2% this year through June, according to HFR. It has been a very tough year for most hedge fund managers, particularly macro managers, a category that broadly includes Dalio. Last year, Dalio’s main Pure Alpha fund only returned 5%. The year before, its returns were basically flat.

While a good year for All Weather is just about the best thing that could happen for Dalio’s business, he has suffered a different kind of setback this year. He has had to give up on his effort to build a new $750 million Bridgewater headquarters in Stamford, Ct., that included $115 million of state incentives such as tax credits. Local opposition killed the plan and for now Bridgewater remains headquartered in Wesport, Ct.

Global macro hedge funds are showing signs of life after weathering a difficult period.

These funds, which bet on movements in instruments as diverse as bonds, equities, currencies and commodities, are famous for large returns and big directional trades by the likes of billionaire George Soros. In recent years, the funds' returns have been hurt by the difficulty of predicting the moves of politicians and lawmakers.

The early signs this year weren't especially encouraging. Bets that the dollar would continue its rise against the yen and that U.S. Treasury yields would move higher—both trades that worked last year—proved wrong.

But in recent months, some funds have started to produce better numbers, helped by gains in equities in developed and emerging markets, as well as a recent rise in Treasury yields.

One of the year's top performers in the macro-fund sector is London-based Pharo Management (UK) LLP. Its $460 million Pharo Trading Fund, run by Guillaume Fonkenell, gained 19.9% in the first five months of the year. Its $4.1 billion Pharo Macro Fund was up 8%, according to the firm. It said June numbers weren't yet finalized.

London-based Omni Partners LLP, which manages about $650 million, saw its macro fund gain 1.6% in the first 13 days of June, taking gains this year to 4.4%, according to data from a large hedge-fund investor that was reviewed by The Wall Street Journal. Omni didn't respond to a request for comment.

Moore Capital's $3.6 billion Moore Macro Managers, run by Louis Bacon, rose 1.46% from June 1 to June 19, putting it up 2.57% for 2014, according to a spokeswoman for Moore. Moore's flagship Global Investment Fund, which is also run by Mr. Bacon and which had suffered losses through the end of May, was up 1.23% in the first 19 days of June, the spokeswoman said. It was still down 3.75% this year.

And while Tudor Group's $7.2 billion Tudor BVI Global Fund and Caxton Associates LP's $4.8 billion Global Investment fund are both still down this year, Tudor gained 1% from June 1 to June 13 and Caxton rose 1.5% from June 1 to June 16, according to the data from the large hedge-fund investor. Caxton and Tudor didn't respond to a phone call and an email seeking comment.

Early numbers from hedge-fund researcher HFR showed macro funds posted a marginal gain in June, on average. This would be the third consecutive month of gains for the strategy, which was up 0.7% in the first five months of the year. The average hedge fund is up just over 2% this year through early July, according to HFR, a research firm. In 2012 and 2013, while the average hedge fund posted solid single-digit returns, macro funds were in negative territory. And while macro funds beat the wider market in 2011, they were still down almost 5%, according to HFR.

While small, the gains this year are welcome after three consecutive calendar years of losses for macro traders from 2011 to 2013.

Roberto Botero, director of portfolio advisory at Sciens Alternative Investments, an investment firm that invests with hedge funds, said funds are finally seeing the benefits of changing their portfolios last year to position for the Federal Reserve's tapering of its bond-buying program and for emerging markets to have staged their early-year rebound.

"The turnaround in [macro funds'] portfolios has started to pay off," he said. "For some names, we're seeing a period of [better returns], but it's still very early days."

He said some funds are betting the U.S. dollar will gain against the Chinese yuan, and some are shorting the euro, or betting that it will fall, and investing in higher-yielding currencies of countries with strong commodity sectors.

Even one of the worst-performing hedge funds this year has made gains recently. London-based Rubicon Fund Management LLP's $850 million Global Fund gained 1.8% in the first 13 days of June, although it was down 17.7% this year, said a person who had seen the numbers. The fund returned more than 18% last year, the person said.

But some continue to struggle. Brevan Howard's $27 billion Master Fund lost 0.3% in June, said a person familiar with the matter. This takes its losses in the first half of the year to around 4.4%, raising the prospect of the first negative year in the fund's history.

A letter to investors for May—the firm's latest—reviewed by The Wall Street Journal said the fund would suffer losses on the short end of the bond yield curve in Europe if interest rates rose.

Brevan Howard declined to comment.

Some investors now think that the dwindling influence of the Federal Reserve as it cuts back its stimulus and the emergence of trends as major economies head in different directions could offer more lucrative trades for macro funds. Investors point to Thursday's robust U.S. nonfarm payrolls data as providing more direction for the dollar and bond yields.

"Now a lot of the political surprise has gone [from markets], there surely has got to be some fixed-income macro money to be made based around tapering," said Chris Jones, managing director at Bfinance, which advises investors on their hedge-fund allocations.

Anthony Lawler, who manages portfolios of hedge funds at GAM, an investment manager, said macro trading was tough, but currencies and bond markets could move in different directions as economies such as China and Brazil slow, while India, the U.S. and Japan grow.

"In traditional macro markets, we are seeing opportunities as a result of differing country growth and policy paths," he said. Macro traders are taking positions such as betting that the U.K. pound will rise, that the dollar will gain against the yen and euro, and buying European and Japanese stocks, he said.

But some investors remain skeptical.

Robert Duggan, managing director at fund of hedge funds investor Skybridge Capital, said his funds hadn't invested with macro managers for several years and his firm was "definitely" still negative on the strategy. "If there's a big 'risk-off' period they're not going to do well," he said.

Today’s bull market is the fourth biggest since the 1929 crash after stocks have nearly tripled since the financial-crisis low set in early 2009.

But more than any modern bull market, this one stands alone in that it’s squarely out of step with economic growth. It’s being driven higher by just a few wealthy participants and traders who have tacitly, perhaps even unknowingly, agreed to drive prices higher.

The main reason for that is two-fold.

First, low interest rates have made other investments unattractive. The 10-year U.S. Treasury is yielding only 2.58%. Inflation is running at an annual rate of 2%. That makes corporate bonds, certificates of deposit (which yield less than T-bills) and other fixed-income products largely a losing proposition. Those who have been buying bonds have been doing so for safety.

Second, the investing public isn’t really buying stocks. A study by the Pew Research Center, published in May, found stock ownership by households is shrinking, at 45%, down from more than 65% in 2002. Even with the Dow Jones Industrial Average reaching the 17,000 milestone, investors are leaving stock mutual funds, not buying them.

This series of circumstances is unique. Unlike central bankers’ response to the Great Depression, the Federal Reserve has embraced Keynesian economics and flooded the economy with dollars on a scale never seen before. The Fed’s balance sheet has more than quadrupled to $4.3 trillion since 2008.

In short, stocks have become more attractive not because of a surging economy or strengthening corporate profits, but because they are the last-place finishers in an ugly contest. That’s a significant difference with boom markets of the past.

For instance, between 1935 and 1937, the stock market lagged an economic recovery. U.S. gross domestic product rose 10.8% in 1934 and 8.9% in 1935. But stocks only took off in that last year, eventually logging a 132% increase until 1937. In that last year, economic growth was robust, but it came crashing down in 1938. GDP contracted 3.3%, and deflation added to woes, with prices falling 2.8%.

The next long-term bull market occurred from 1942 to 1946, when stocks jumped more than 150%. That isn’t a good comparison, given the nation’s involvement in World War II. But there were some robust years economically. And once again, the market moved along with the economy: a 17.7% growth rate in 1941, followed by 18.9% in 1942, 17% in 1943 and 8% in 1944. Much of the growth was offset by inflation (9% in 1942), but at least investors had a reason to buy.

The first post-war bull market began in 1949 and lasted nearly seven years. Stocks rose more than two-fold as U.S. GDP grew at least 4.1% in each of those years, including an 8.7% growth rate in 1950. The Dow Jones Industrial Average finally passed its 1920s record high in 1954. Inflation was all over the map. Prices rose 8.7% in 1951, but increased at about 1% or lower between 1953 and 1956.

The mid-1980s bull market saw stocks, as measured by the S&P 500, double during a five-year period beginning in 1982. Like the current bull market, gains were made to seem bigger after the S&P 500 dropped to only 102.42 in the summer of 1982. But again, there was economic growth that exceeded historical levels — between 3.5% and 7.3% during the rally — and inflation and unemployment fell during that time.

Some describe the period from 1987 to 2002 as a bull market. Technically, it may be. It rose more than 500% during that span. But the real bull market of this era occurred between the start of 1995 until early 2000. Stocks in the S&P 500 rose 237% as GDP increased between 3.8% and 4.8% annually. Inflation was low, between 1.6% and 3%. Unemployment fell each year, starting at 5.6% and ending at 4%. Yes, some of this gain was fueled by unrealistic expectations about dot-com companies, but there was real economic growth underneath it too.

In all of those periods, the market reflected strong economic trends: solid growth, high or strengthening employment and stable inflation. Only the latter is present today. The unemployment rate is improving, but it’s still a relatively high 6.1%. The best GDP rate produced since the financial crisis was 2.8%. That was in 2012, before the current bull market really took off.

Perhaps, as some suggest, this is a new normal. If so, it represents a disconnect between economic reality and market valuation. More likely, it’s a warped market distorted by the extraordinary measures used to create an economic lift.

As market indexes touch new highs, investors should ask themselves if they’re taking part in a history-making rally, or a rally that is ignoring history.

Here’s another sign the bull market in stocks may be nearing an end: Companies have dramatically reduced share repurchases.

New stock buybacks fell to $23.2 billion in June, the lowest level in a year and a half, according to fund tracker TrimTabs Investment Research. In May, the total was just $24.8 billion, and the monthly average in 2013 was $56 billion.

That’s worrisome, according to TrimTabs CEO David Santschi, because “buyback volume has a high positive correlation with stock prices.” (click on image below)

How high? Consider the correlation coefficient, a statistic that reflects the degree to which two series tend to zig and zag in lockstep. It ranges from plus 1 (which means the two series are perfectly correlated) to minus 1 (the two move inversely to each other). A zero correlation coefficient would mean there is no detectable relationship between the two series.

According to Santschi, the correlation coefficient between monthly buyback volume and the stock market’s level, for the period from 2006 until this spring, was 0.61. That’s highly statistically significant.

A high correlation also makes theoretical sense. That’s because, when a company announces a share-repurchase program, it sends a strong signal that its management really thinks its stock is undervalued — so much so that it’s willing to put its money where its mouth is. So it’s bullish for the overall market when lots of companies are simultaneously announcing such programs.

To be sure, the monthly buyback data are quite volatile, so two months of anemic numbers don’t automatically doom the market. Santschi, for one, says that, if the slow pace continues through July, “we will become very concerned.”

Hedge-fund manager Douglas Kass, president of Seabreeze Partners Management, relates the slowdown in buybacks to the recent M&A wave. He says that both activities represent the implicit recognition by corporate managements that their internal operations are unable to produce sufficient revenue growth to maintain their stock prices.

Over the past five years, for example, per-share sales growth for S&P 500 companies has been an annualized 2.4%, lagging far behind the 20% annualized earnings per share growth rate. One of the ways in which corporate managers have been able to extract that much EPS growth out of such anemic sales growth, Kass argues, is through share repurchases.

As their share prices become more and more inflated, however, corporate managers become increasingly reluctant to buy them. The logical thing to do instead is buy up other companies, paying with shares of their inflated stock.

That’s what is happening now, Kass argues: “There’s a baton exchange from buybacks into M&A activity.”

And, as I detailed at greater length in my column earlier this week, past M&A waves have all ended with a precipitous decline in stock prices.

Billionaire activist investor Carl Icahn said on Thursday that it is time for U.S. stock market investors to tread carefully after the run-up on Wall Street.

"In my mind, it is time to be cautious about the U.S. stock markets," Icahn said in a telephone interview. "While we are having a great year, I am being very selective about the companies I purchase."

U.S. stocks fell on Thursday as concerns about the financial health of Portugal's top listed bank gave investors a reason to cash in recent gains. The S&P 500 fell as much as 1 percent at one point before sharply rebounding, to close down -0.41 percent at 1964.68.

Icahn has been pressuring discount retailer Family Dollar Stores Inc to sell itself. On Thursday, Family Dollar said its profit fell by a third as it cleared inventory ahead of planned store closures and competition intensified.

Icahn, Family Dollar's largest shareholder with a 9.4 percent stake, wants the company to sell itself to rival Dollar General Corp to help them cope with stiff competition from big-box retailers such as Wal-Mart Stores Inc.

Icahn said: "The leadership, to say the least, is questionable at Family Dollar and it's been that way for many years. Howard (Levine) might be a nice guy but he is far from the right leader for Family Dollar."

Icahn added: "We believe Family Dollar and Dollar General should merge as they would make for perfect partners. It is obvious that Family Dollar, especially in light of its record and the looming competition on the horizon, could use a partner.

"However, unfortunately, the announcement of Dollar General Chief Executive Rick Dreiling's retirement is a setback to an activist player like us that would like to accelerate this process but it doesn't mean it is insurmountable on a long-term basis" with regards to a possible merger between Dollar General and Family Dollar.

The first two payments were made in paper bags. The last installment came in a shoebox. The handoffs all came at a Sacramento hotel near the Capitol.

In a stunning admission covering years of corruption, the former chief executive of CalPERS said Friday he accepted $200,000 in cash, along with a series of other bribes, from a Lake Tahoe businessman who was attempting to influence billions of dollars in pension fund investment decisions.

Fred Buenrostro, who ran the nation’s largest public pension fund from 2002 to 2008, pleaded guilty in U.S. District Court to a charge of conspiracy to commit bribery and fraud. He has agreed to cooperate with federal prosecutors as they pursue charges against his longtime friend, Nevada businessman Alfred Villalobos, a former CalPERS board member.

Buenrostro, 64, said that Villalobos plied him with casino chips and a trip around the world, plus a high-paying job with his investment firm after leaving CalPERS. He also admitted working with Villalobos to create phony documents to ensure that Villalobos earned his multimillion-dollar fees representing a Wall Street private equity firm seeking CalPERS investments.

Most of those allegations had been aired publicly already. What was new Friday was the blockbuster admission that Buenrostro took $200,000 in cash from Villalobos. In his written plea agreement, Buenrostro said Villalobos paid him in three installments in 2007, “all of which was delivered directly to me in the Hyatt hotel in downtown Sacramento across from the Capitol.”

According to Buenrostro, Villalobos told him to be careful how he deposited the cash in order to avoid detection by banking authorities. “Villalobos told me to be sure to ‘shuffle’ the currency before making any deposit, as the bills were new and appeared to be in sequential order,” Buenrostro wrote.

Later, after he’d left CalPERS and the investigation into their relationship gained momentum, Buenrostro said he accepted an additional $50,000 from Villalobos, paid by check.

The former CEO’s guilty plea is the latest chapter in a corruption scandal that first surfaced in 2009 at the California Public Employees’ Retirement System. Documents showed that Villalobos, a former deputy mayor of Los Angeles, had earned $50 million helping his Wall Street clients win investments from CalPERS over several years.

“We condemn the misconduct and ethical breaches admitted today by Mr. Buenrostro,” CalPERS said in a prepared statement. “CalPERS looks forward to justice being served in this case and for the individuals involved to be held accountable for their actions.”

After years of denying any wrongdoing, Buenrostro faces up to five years in prison and a $250,000 fine when he’s sentenced Jan. 7. He remains free on bond.

“There is no question that the chickens have come home to roost for Mr. Buenrostro,” said his lawyer, William Portanova of Sacramento, after a brief court hearing. “He is starting a new chapter in his life. He is a 64-year-old man who is ready to tell all.” Buenrostro declined to comment as he left the courtroom.

His old friend Villalobos will continue to fight charges filed in the case, said Villalobos’ defense attorney Bruce Funk.

“We don’t think there’s any truthful information (Buenrostro) could give that could affect Mr. Villalobos,” Funk said after the court hearing.

The criminal trial was supposed to begin earlier this week with jury selection. Instead, it has been postponed, probably until the fall. Villalobos, 70, is in poor health and wasn’t in court Friday. He listened to the proceedings by phone.

Buenrostro, in his plea agreement, admitted taking bribes large and small. He let Villalobos host and pay for his 2004 wedding at Lake Tahoe. Villalobos took Buenrostro and a CalPERS board member on a 2006 worldwide trip. (The member isn’t identified in the plea agreement, but a state lawsuit filed in 2010 identified him as Charles Valdes, who has since left the board.)

Villalobos paid for his rooms at two Tahoe casinos, Harveys and Harrah’s. And Villalobos delivered on a promise of a $25,000-a-month job for Buenrostro after the CEO left CalPERS in 2008. The job ended two years later, about the time Villalobos and his company filed for bankruptcy.

In 2005, Buenrostro said he watched Villalobos give casino chips to certain CalPERS board members and to Buenrostro’s wife. At the time, CalPERS was considering awarding a pharmacy contract to a health care company.

Buenrostro didn’t identify the company, and said the board members are no longer at CalPERS. In 2011, CalPERS fired a New Jersey drug-distributor, Medco Health Solutions, after it was revealed that Medco had paid Villalobos about $4 million to help win a contract to supply pharmaceuticals to CalPERS members. The firm, which was later sold, paid a $2.7 million fine to settle a state investigation but didn’t admit any wrongdoing.

In addition, Buenrostro said he worked with Villalobos to “cover up the evidence of our corrupt relationship by concealing and destroying records.” In 2010, after he invoked his Fifth Amendment right against self-incrimination during questioning by Securities and Exchange Commission investigators, Buenrostro said, he received a $50,000 check from Villalobos.

Buenrostro said the $50,000 was supposedly a loan, but Villalobos told him he probably wouldn’t have to repay it.

If Buenrostro had gone to trial and been convicted on all charges, he was facing up to 40 years in prison. The conspiracy charge to which he admitted carries a five-year maximum penalty. So far the prosecutors haven’t made any sentencing recommendation, but agreed to ask for a reduced sentence based on Buenrostro’s “truthful cooperation,” said his lawyer Portanova. U.S. District Judge Charles Breyer will sentence him.

The original indictment was fairly narrow. It focused mainly on a series of letters Buenrostro said he created on CalPERS stationery at Villalobos’ behest.

Villalobos’ most important client, Apollo Global Management, had demanded disclosure letters in which the pension fund said it realized that Villalobos would earn fees from Apollo if the firm got CalPERS investments. When he couldn’t get a CalPERS investment officer to sign a disclosure letter, Villalobos turned to Buenrostro, who put together the letters on the pension fund’s stationery, according to the plea agreement.

Buenrostro said no one at CalPERS saw the letters, which Villalobos then mailed to Apollo. The firm got $3 billion of CalPERS’ money in 2007 and 2008, and Villalobos earned fees of $14 million. Apollo has said it wasn’t aware of any wrongdoing.

An investigative report commissioned by CalPERS said it was unlikely that Villalobos and Buenrostro were able to steer investment dollars to Villalobos’ clients. But the report, by Washington, D.C., securities attorney Philip Khinda, said Villalobos’ clients probably charged CalPERS millions of dollars in extra investment-management fees to compensate for the money they paid Villalobos.

The guilty plea marked the latest chapter in the downfall of Buenrostro, a longtime state employee and former deputy director of the state Department of Personnel Administration who became CalPERS CEO in 2002.

Because of his guilty plea to a felony, Buenrostro could have to forfeit a portion of his CalPERS pension, said fund spokesman Brad Pacheco. The amount is to be determined, he said.

The former head of the nation’s largest pension fund admitted Friday that he took bribes, including hundreds of thousands of dollars stuffed in paper bags and a shoe box, and helped an associate collect millions in a fraudulent investment scheme.

Fred Buenrostro Jr. pleaded guilty in San Francisco federal court to fraud and bribery charges stemming from his time as chief executive of the California Public Employees’ Retirement System from 2002 to 2008.

In his plea agreement, Buenrostro said that in exchange for his help Alfred Villalobos, a former CalPERS board member, took him on a trip around the world, gave him casino chips and paid for his wedding in Lake Tahoe, California.

Villalobos denied the allegations through his attorney Friday.

Buenrostro’s guilty plea arises from a years-long investigation into the role of money-management firm middlemen, called placement agents, in helping clients win investment business from a California pension system that controls $300 billion.

CalPERS said the investigation has prompted it to take “aggressive steps to implement policies and reforms that strengthen accountability and ensure full transparency.”

Buenrostro said in his plea that he started taking bribes in 2005 to use his influence with CalPERS to make investment decisions to help Villalobos’ clients. He also said he gave Villalobos, a CalPERS board member in the mid-90s, access to confidential investment information.

The 64-year-old former executive said he forged letters allowing firms connected with Villalobos to collect a $14 million commissions on $3 billion pension fund investments. He said he started writing bogus investor disclosure letters after CalPERS legal and investment officials declined to authorize them.

Further, Buenrostro said after he left CalPERS and went to work for Villalobos that he accepted $50,000 to lie to federal investigators in 2010 about their relationship.

Buenrostro faces five years in prison and a $250,000 fine when he is sentenced in January. In exchange for a lesser sentence, Buenrostro has agreed to co-operate with the continuing investigation of Villalobos, said Buenrostro lawyer William Portonova. “He got tired of lying,” Portonova said. “He’s ready to tell the truth.”

Villalobos has pleaded not guilty to fraud charges and other related counts. His attorney, Bruce Funk, said his client denies the claims contained in Buenrostro’s plea agreement. “If he’s truthful, there is nothing he can say that will hurt Mr. Villalobos,” Funk said.

Buenrostro and Villalobos, 70, also face two government lawsuits.

The state attorney general sued in 2010, saying Buenrostro and Villalobos, along with other former pension board and staff members, participated in kickback scheme.

At that time, the attorney general obtained a court order freezing assets of Villalobos and his company in an attempt to recover more than $40 million in commissions. Villalobos filed for bankruptcy later in 2010. His assets included 20 bank accounts, two Bentleys, two BMWs, a Hummer, art worth more than $2.7 million and 14 properties in California, Nevada and Hawaii. None of Buenrostro’s assets were seized.

State attorney general spokesman Nick Pacilio said a trial is scheduled for Sept. 8 in San Francisco Superior Court.

The Securities and Exchange Commission has also filed a lawsuit in 2012, which is still pending.

In a related sanction, the state’s campaign watchdog, the Fair Political Practices Commission, fined other executives and investment managers in 2011 for failing to report gifts that included food, wine and baseball and Rose Bowl tickets.

The California Public Employees' Retirement System CEO who oversaw the multimillion-dollar pay-for-play scandal that rocked the nation's largest public employee pension fund, pleaded guilty to conspiracy to commit bribery and fraud in federal court in San Francisco on Friday. And he agreed to "tell all" about his chief cohort's role in the affair.

As part of the plea, Fred Buenrostro, 64, who led CalPERS from 2002 to 2008, admitted to numerous offenses, including receiving cash, casino chips and other goodies from former CalPERS board member Alfred Villalobos, who has also been charged.

"He is starting a new chapter in his life. He is a 64-year-old man who is ready to tell all," said Buenrostro's attorney, William Portanova. Meaning there's more to come about the scheme, which began in 2005, to steer CalPERS investments to certain private-equity firms, who paid Villalobos up to $50 million for his services as a CalPERS "placement agent."

Villalobos, 70, a former deputy mayor of Los Angeles, has pleaded not guilty and is due to stand trial on a date to be set. "We don't think there's any truthful information (Buenrostro) could give that could affect Mr. Villalobos," said his attorney, Bruce Funk.

"We condemn the misconduct and ethical breaches admitted today by Mr. Buenrostro," the 1.6 million-member pension fund said. "CalPERS looks forward to justice being served in this case and for the individuals involved to be held accountable for their actions."

The alleged actions, according to state and federal court documents, an independent 18-month investigation by Washington attorney Philip Khinda, and admissions by Buenrostro on Friday, included:

-- Paper bags and a shoe box containing $200,000 from Villalobos to Buenrostro in exchange for confidential information and the latter's influence in directing CalPERS investments to Villalobos' clients.

-- Forging CalPERS documents.

-- A $50,000 loan from Villalobos in return for Buenrostro's refusal to testify before the Securities and Exchange Commission about the affair.

-- First-class airfare, hotels, meals and casino chips paid by Villalobos for Buenrostro's business trips overseas.

-- Buenrostro's 2004 wedding at Villalobos' Lake Tahoe mansion, paid for by Villalobos.

Buenrostro was, according to testimony in court documents, Villalobos'"puppet."

"It's a good day for justice, and it was time for Mr. Buenrostro to admit his wrongdoing," said Khinda.

The puppet, meanwhile, faces a possible five-year sentence and $250,000 fine at his next scheduled court appearance Jan. 7. The now-bankrupt puppet-master, if found guilty, faces up to 60 years in prison.

The ex-CEO of CalPERS, Fred Buenrostro, has just pleaded guilty to accepting doucers, cash bribes and fees for placing investment business with a specific firm. The economic point that this helps us elucidate is why bankers and fund managers make such vast incomes normally. It’s a concept called “efficiency wages”. Essentially, when stripped right down, if people are handling or responsible for a large amount of money then pay them very well. So that it’s not actually worth their trying to do anything naughty, the risk of losing that high income is greater than what they can gain by being naughty.

Here’s the actual announcement of Buenrostro’s plea:

Buenrostro is the former Chief Executive Officer (CEO) of the California Public Employee Retirement System (CalPERS). In pleading guilty, Buenrostro admitted to conspiring with Alfred J. Villalobos, founder and operator of ARVCO Capital Research LLC (ARVCO). Buenrostro acknowledged in court today that he understood that Villalobos operated ARVCO as a placement agent that solicited investments by public pension funds into private equity funds. Buenrostro also admitted that he understood that ARVCO was typically paid an agreed-upon fee based on the percentage of the total dollar amount invested by the public pension fund.

To put it simply (and do note that Villalobos has not been found guilty of anything at all as yet and is thus innocent of all charges) there’s a layer of agents, or introducers, in the fund management industry. A pension fund, say, is looking around for where to invest, various fund management firms are looking for people to invest and those who introduce one to the other will get a (small) slice of the amount invested. The accusation is that Buenrostro favoured Villalobos in such allocations and then received various parcels of cash, had his wedding paid for etc. as a result. Again, note that Buenrostro has pleaded guilty, Villalobos is innocent.

So far so grubby: but this gives us an insight into why pay is so darn high right across the fund management and financial industry. Simply because these people are handling such vast amounts of money. There’s therefore obviously a temptation to make off with some of that vast river of cash that flows through such offices.

As the excellent Falkenblog explains:

The reason we pay people a lot is because we think they are worth it. Many times they are not, but not always. A fund I know shut down one of its funds and people there basically gave away their positions before they left, making payments to the favor bank, for when they went to their new jobs. Why? They were told there would be no bonus, just exit your positions, and get your 1 month severance. A zero bonus is a horrible incentive structure for someone in charge of a portfolio, and it is not feasible to think your back office or audit group can monitor this. The portfolio managers know the best price, outsiders don’t, that’s why they get paid a lot. In the context of a moving market, and illiquid securities (such as mortgages), you don’t really know how much money you are leaving on the table, but look at the incentives at the individual level, and expect people to act in their self interest.

We can look at the amount these people are making and shout “That’s inefficient!”. But when we think about how much it can cost us if they’re not motivated to do the best they can for us then it might be more efficient to pay them those vast sums and not have them dealing inefficiently for us. Thus this idea of efficiency wages.

We don’t actually know exactly what Buenrostro’s pay packet was but we do have an indication from his successor:

A CalPERS spokesman in Sacramento said he wasn’t sure what Stausboll would earn as CEO, but that the job’s annual salary range previously set by the fund’s board was $224,000 to $336,000. She also will be eligible for an annual bonus worth up to 40% of her base pay.

A third of a million is obviously pretty good pay for someone on the public dime, even in fund management. But compared to the wider industry averages it’s a pittance:

Hedge fund professionals have seen higher compensation for the third consecutive year, with the average salary for an entry-level analyst at a mid-performing hedge fund totaling $335,000 in 2013, an industry report has found.

Portfolio managers at large hedge funds should also be grinning right now, given that average salaries have reached $2.2 million, the 2014 Glocap Hedge Fund Compensation report, released Thursday found.

Hedge fund management and pension fund management are not exactly the same thing, this is true, although they are close neighbours. And we should also note that CalPERS is one of the largest pension fund investors with some $260 billion under management. But if we take this idea of efficiency wages seriously then we might start to say that paying the CEO of one of the largest pensions funds less than the starting salary of a closely comparable job then we’re not in fact being efficient about the wages being paid. For we want the salary and income of those handling those vast sums to be too high for them to consider damaging the investment performance of the fund in order to gain some increase to their own income.

This is of course a subset of the principal/agent problem. If someone’s responsible for investing $260 billion then how do we make sure that they invest it to the benefit of the fund holders, the principals, rather than to the benefit of the manager, the agent? As with other finance industry professionals, as with other occupants of C suites around the country, one answer is to pay them in wages and salary more than they could be making from crooked dealings. It’s therefore possible that very high wages, those millions of dollars a year, are in fact efficient wages.

Sadly, this is precisely the opposite of what CalPERS was doing around the turn of the century:

For two years running, the members of the board of the California Public Employees’ Retirement System, the roughly $150 billion pension plan commonly called Calpers, have been at one another’s throats.

The state controller, an elected official who serves on the board, successfully sued Calpers to limit its investment managers’ pay — a policy that recently helped prompt the fund’s chief investment officer to quit.

How limited was that pay?

The latest sign of trouble at Calpers came two weeks ago, when Daniel Szentes, the chief investment officer, quit after only 15 months. He told the board that his resignation was prompted in part by a recent court ruling that would force Calpers to trim the salaries and bonuses of some of its investment managers, making it harder to recruit talent. Salaries range from $88,000 to $105,000, according to Calpers, a fraction of what many money managers make in private industry.

We cannot, of course, link those limits on pay directly to the Buenrostro events of a few years later. There are bad apples in any barrel and they don’t have to be indicative of any larger trend; they can just be bad apples. But it is interesting that theory tells us that there could be a good case for very high salaries among those who manage money in order to deter little side deals that increase income. And that an organisation that deliberately and specifically paid well under market salaries found side deals going on.

To put the entire idea of efficiency wages into a nutshell: pay people enough that they’re too scared to steal from you for fear of losing their well paid jobs. And the more money people handle the more that pay is going to have to be given that there’s a great deal more they can steal. All of which is one explanation, perhaps not the complete one but at least part of it, why salaries in finance and fund management are so high: because Buenrostro.

I'll never forget my due diligence experience with some of these charlatans. It took me less than 15 minutes to figure out Norshield was a Ponzi scheme. Johnny "X" (John Xanthoudakis) walked into the boardroom sporting a tan, wearing a fancy Italian suit, smiling with his bleached white teeth, flaunting his "incredible risk-adjusted returns," a perfect 45 degree line. When I told him they are "too good to be true," he asked me if there was anything he could do to "facilitate an investment" (code for "how much to bribe you?"). That meeting was over fast. Amazingly, municipal pension plans in Quebec invested hundreds of millions in this joke of an outfit (too many of them are on the take; you better believe it is time to take action on municipal pensions).

...my biggest beef is governance. When I was working at the Caisse investing in hedge funds and funds of funds, it took me 15 minutes to figure out Montreal's Norshield Asset Management was a fraud. Amazingly, the city of Laval and Sherbrooke invested millions in this fund of funds run by John Xanthoudakis, a real slick (and not particularly bright) snake. It made me wonder how many city officials he greased to get them to invest in his Ponzi scheme.

Governance, governance, governance! I can't stress this point enough. Everyone wants a piece of the pension pie and now more than ever, pension fund managers and their supervisors need to be vigilant. 

Japan's private pension funds, which control roughly ¥90 trillion ($888 billion), are turning away from the dismal returns offered on Japanese government debt and instead buying higher-yielding assets, from real estate to catastrophe bonds.

They join the $1.25 trillion public pension fund in moving away from unappealing sovereign bonds where the yield on the 10-year note fell to 0.530% Friday, the lowest in over a year and close to a record low. The shift has been helping spur Japan's property market and bring growth to new investment areas such as bank loans and infrastructure.

It is a switch for the private pension funds, which have for years invested mostly in domestic debt as the country's deflationary environment was good for bonds. Now, worries are growing that buoyed by the Bank of Japan's aggressive bond-buying program, the market may be primed for a big fall as inflation picks up and investors demand higher yields.

Responding to low-yield environment is a challenge for investors globally, and changes to the portfolios by Japanese private pensions are relatively small so far. But with almost a trillion dollars at stake, even small moves can translate into significant inflows or outflows for markets. A survey by J.P. Morgan Asset Management of 127 corporate pension funds released in late June found they had cut Japanese debt to 34.1% at the end of March, the lowest since comparable data became available in 2009 and down from 34.9% a year earlier.

And unlike the giant Government Pension Investment Fund, which is considering adding more domestic stocks to achieve higher returns, the private funds are souring on local equities. Their allocation to stocks at home fell to 11.4% from 11.8%, and they instead bought more foreign bonds, purchased bank loans and invested in infrastructure in the hopes of strong returns to help secure payouts for their pensioners.

Toru Higuchi, who oversees ¥700 billion in investments at the Teachers' Mutual Aid Cooperative Society, added a maximum 2% allocation to both global and Japanese real-estate investment trusts, and the same amount to hedge funds by March. He is now considering investing in private equity and companies deemed socially responsible.

Yoshi Kiguchi, chief investment officer at Okayama Metal & Machinery Pension Fund, which manages ¥45 billion, has increased the weight of shorter-term corporate bonds to 11% from 7% last year. These bonds offer higher yields than government bonds.

The ¥150 billion pension fund of copier-maker Ricoh Corp. last autumn added a 4% allocation to snapping up real estate and infrastructure projects, another 4% to credit products such as bank loans and 5% to nonlife insurance-linked products. These products include securities such catastrophe bonds issued on behalf of insurers that offer significant returns if there are no disasters, but can be wiped out in the event of a catastrophe.

The changes offer a snapshot into how investing in Japan is changing under "Abenomics," a program to bolster the country's long-troubled economy. The central bank has deliberately pushed down bond yields to encourage investors to buy riskier assets, and while some new investments benefit companies at home, others are venturing abroad, where higher returns are more likely.

"We're trying to get our 3% return target with as little risk as possible," said Jun Mori, who helps oversee Ricoh's pension investments. "That means investments that offer a stable return with few ups and downs." The fund returned 4.5% in the fiscal year ended in March.

Pension consultants say money managers who run the private pensions generally prefer investments with a steady stream of income that beats bond yields but with potentially less price fluctuations than stocks. Many don't seek higher risk because their investment targets are relatively low by international comparison amid a low-yield environment. According to consultancy Towers Watson, their target was 2.33% on average in 2012, compared with 7.17% in the U.S.

"Corporate plans aren't worried about funding, so there is no need to take too much risk," said Toru Moriyama, deputy manager in the pension fund management division at one of Japan's largest trust bank, Mitsubishi UFJ Trust and Banking Corp. He said recent gains in local shares and a weaker yen have helped their financial footing.

The funds are still hesitant about domestic stocks, even after a nearly 50% rise in the Nikkei Stock Average since the end of 2012, as many pension managers still can't forget years of poor returns. The benchmark Nikkei Stock Average is still down 60% from its 1989 peak, and has fallen 6% this year, making it among the world's worst performers.

Some managers are also reducing stockholdings because they anticipate more stringent regulatory requirements after banks and life-insurance companies were forced to reduce stockholdings. In addition, more companies are limiting risk in their pension funds as they are required to reflect pension finances on their balance sheets.

"If we don't manage it well, that will have a negative impact on the company's balance sheet…It's not a good idea to do what could drag down our core business," said Yuji Horikoshi, chief investment officer of Mitsubishi Corp.'s ¥280 billion pension fund.

The fund lost 0.8 percent on its investments in the final three months of the fiscal year, trimming assets under management to 126.6 trillion yen ($1.2 trillion), GPIF said today in a statement. Its Japanese shares dropped 7.1 percent in the period. The fund’s annual return of 8.6 percent, buoyed by an equity rally in the first three quarters, compared with a record 10.2 percent the previous year.

GPIF has been under increasing pressure to cut domestic bonds in favor of riskier assets since a government panel last year urged an overhaul of its investment strategies. Its results illustrate both sides of the argument over whether the fund should own more stocks: the quarter to March underscores the potential for short-term equity losses, while full-year gains would have been better if GPIF owned more shares instead of local debt that delivered just 0.6 percent.

For all the concern fixed-income assets will tumble once the central bank boosts rates, the Treasury Department still managed to get investors to submit $3.4 trillion of bids for the $1.12 trillion of notes and bonds sold this year, according to data compiled by Bloomberg. That represents a bid-to-cover ratio of 3.06, the second-highest on record and up from 2.88 in all of last year.  

Akira Amari has a good ear for a catchphrase. At a press conference this month Japan’s economy minister assured his audience that the pick-up in Japan’s economy was going according to plan, about 18 months in to the regime of Prime Minister Shinzo Abe. “Last year it was a case of ‘Japan is back’,” he said. “This year, it is ‘Japan is on track’.”

But investors in the country’s Y854tn ($8.4tn) bond market see things differently.

Since the government threw the covers off its revamped growth strategy last month – the so-called “third arrow” of the three-point plan – bonds have rallied, pushing yields down. Meanwhile, the inflation-linked bond market suggests that expectations for average price rises have levelled off at about 1.1 per cent over the next 10 years, excluding the effect of tax increases.

One conclusion is that the government will struggle to deliver on its promises to galvanise the world’s third-largest economy, while the Bank of Japan will fall well short of its 2 per cent target for inflation.

The latest version of the growth strategy – majoring on tax cuts, corporate governance reforms and measures to strengthen the workforce – was much ballyhooed. But analysts note that virtually the entire yield curve has shifted downwards since near-final policy documents began to circulate at the end of May.

Rather than lift expectations for the country’s potential growth rate, it may have done the opposite, says Jun Ishii, strategist at Mitsubishi UFJ Morgan Stanley Securities, likening Mr Abe’s team to Japan’s well-meaning but ineffective World Cup footballers in Brazil.

“While the strategy’s goals are trying to push Japan in the right direction, there is doubt as to whether the administration has the wherewithal to get the job done,” he says.

As for the stalling in inflation expectations, many point fingers at Bank of Japan governor Haruhiko Kuroda, who said last month that core CPI could drop as low as “about 1 per cent” over the summer, from about 1.4 per cent now (minus the effects of April’s consumption tax increase).

To some, that crystallised doubts at the heart of the prime minister’s eponymous “Abenomics” project. Though Mr Kuroda maintains that CPI should resume its progress toward 2 per cent from the autumn, pushed up by higher wages and a narrowing output gap, few share his confidence, says Tomohisa Fujiki, interest-rates strategist at BNP Paribas in Tokyo.

Many bond market participants still feel that, without a boost from yen depreciation or fiscal stimulus – the main effects of arrows one and two, unleashed early last year – CPI has no real reason to climb.

“People are wondering how inflation is supposed to pick up,” says Kazuto Doi, who manages about $20bn of bonds at Western Asset Management in Tokyo. “That is one of the most mysterious parts of Mr Kuroda’s communication.”

There are mitigating circumstances for the recent surge in bond prices. The European Central Bank’s interest-rate cuts in early June have “repriced” other markets via global investment flows, notes Tomoya Masanao, head of portfolio management at Pimco Japan.

Analysts say the picture also has been distorted by the effects of the BoJ’s loan-support programme, which pumped an extra Y4.9tn of liquidity into the market on June 18. In the absence of corporate demand for credit, much has found its way into bonds, say brokers.

“There are very firm, tight conditions,” says Akito Fukunaga, chief yen rates strategist at Barclays in Tokyo. “We haven’t got any inventory left.”

And some argue that it is difficult to come to any firm conclusions about the market’s growth and inflation expectations. Such is the force of the BoJ’s main easing programme – mopping up some Y7tn of JGBs a month, equivalent to more than two-thirds of net issuance of coupon-bearing debt – that current price signals emanating from this thinly traded market are unreliable, they say.

According to Goldman Sachs estimates, 10-year bond yields would be around 1.2 per cent – consistent with a more vigorous economy – in the absence of “quantitative and qualitative easing”, or QQE.

But so far this year the benchmark 10-year yield has spent 50 days below 0.6 per cent – longer than during the extreme demand-driven markets of the summer of 2003 and April 2013, when yields plunged to record lows before rebounding. That hardly bodes well for a resurgent Japan.

“The government’s growth strategy has not yet succeeded in raising growth expectations meaningfully,” says Mr Masanao.

The U.S. House of Representatives on Tuesday overwhelmingly passed a $10.9 billion extension of U.S. transportation funding through May 2015, a measure aimed at averting cutbacks in August in federal money for road, bridge and transit projects.

The measure, paid for largely through revenue generated by pension accounting changes and higher customs user fees, passed on a 367-55 bipartisan vote, despite opposition from outside conservative groups.

Senate Majority Leader Harry Reid said that "as soon as I can get to it," the Senate would begin considering a similar, $10.8 billion measure with some alternate funding provisions in the coming days.

Without new money for the Highway Trust Fund, the Department of Transportation has said it will start to cut back federal funding for projects by nearly a third starting on Aug. 1, the same day Congress begins a five-week summer recess.

"If Congress fails to act, thousands of transportation projects across the country and hundreds of thousands of construction jobs will be at risk," said House Transportation and Infrastructure Committee Chairman Bill Shuster, a Pennsylvania Republican. "This legislation provides much needed certainty and stability for the states."

The Highway Trust Fund, which has been supported by fuel tax revenues since its inception in 1956, has run chronically short of money in recent years because of higher construction costs and improved vehicle fuel economy. Trucking firms and many other industry groups favor higher fuel tax rates, unchanged since 1993, to return it to solvency.

But House Republicans have ruled that out, and the biggest revenue source in the House-passed bill is often called "pension smoothing," which allows companies to reduce near-term contributions to employee pension programs by assuming a higher, historical average rate of return. That move is expected to boost corporate tax collections by the U.S. Treasury by about $6.4 billion over 10 years.

WHITE HOUSE WELCOMES EXTENSION

The bill would transfer $1 billion in existing money to construction projects from a fund that helps pay for cleanup of leaking underground fuel storage tanks.

The $10.8 billion companion measure passed by the Democratic-controlled Senate Finance Committee would also fully fund transportation projects through May, although it would rely less heavily on pension changes and more on revenues from measures to boost tax compliance.

The White House said on Monday it would welcome the 10-month extension, to the chagrin of some Democrats who say it would push any decisions on long-term funding to a newly elected Congress next year. Among those is California Senator Barbara Boxer, who Reid said would get a Senate vote on her plan for a shorter, $8 billion extension. Boxer has argued a shorter extension is needed to force Congress to act on a long-term funding plan during the "lame duck" legislative session after November elections.

On Monday night the White House endorsed the House Republicans’ plan to keep the Highway Trust Fund—which finances highways, roads and bridges—alive for the next 10 months, saving about 700,000 jobs. While the bill will bring the Transportation Department program back from the brink of a crisis, it uses an accounting trick known as “pension smoothing” to pay for it. Here’s a guide on why the short-term revenue raiser is no good for the long haul.

What is pension smoothing and why should I care about it?

Pension smoothing raises money for the government in the short term in exchange for increasing the debt over the long term. By reducing pension contribution requirements, pension smoothing temporarily increases companies’ taxable income to raise revenue for the government. But over the long-term, companies will be on the hook to contribute more to their pension funds, lowering tax revenue. Some conservatives, including fellows at the Heritage Foundation and Keith Hennessy, a senior White House economic advisor under President George W. Bush, have warned that pension smoothing increases the risk of a taxpayer funded bailout of the Pension Benefit Guaranty Corporation, the government insurance company that protects pensioners from risk in their private plans.

Does anyone like it?

Congress in the past has turned to the tactic in dire situations (see next question) because it is pro-employer and a revenue raiser in the short-term. Since the Congressional Budget Office scores bills in 10-year windows, supporters of the House and Senate bills to save the Highway Trust Fund can avoid questions about raising deficits in the long-term.

It’s no one’s ideal revenue raiser. Sen. Orrin Hatch of Utah, the top Republican on the Finance Committee, told TIME last week he’s “not real happy about pension smoothing,” but still “dedicated” to passing this year’s fix. On Tuesday, reporters asked House Speaker Boehner at a press conference why he would support pension smoothing, which Republicans decried earlier this year as a gimmick when Democrats wanted to use it to fund an emergency unemployment insurance extension.

“These are difficult decisions in difficult times in an election year,” said Boehner. “It is a solid piece of legislation that will solve the problem in the short-term. The long-term problem is still there and needs to be addressed.”

Several outside think tanks and media organizations have announced their opposition to pension smoothing, including the left-leaning Center on Budget and Policy Priorities, the editorial board of the Washington Post, the bipartisan Committee for a Responsible Federal Budget and the conservative Heritage Foundation.

Has pension smoothing been used before?

In 2012, Congress first turned to the revenue-raising gimmick to fill another transportation funding shortfall. Last year, Sen. Susan Collins (R-Maine) included it as part of a failed proposal to repeal an Obamacare provision and end the government shutdown. Earlier this year, Senate Democrats and a handful of Republicans tried to use it to extend unemployment insurance. Now it will be used to save the Highway Trust Fund from insolvency.

What are the alternatives?

A month ago, Sens. Chris Murphy (D-Conn.) and Bob Corker (R-Tenn.) introduced a bill to raise the federal gas tax (currently around 18 cents a gallon), which hasn’t been changed since 1993 and is the main source of financing the Highway Trust Fund. The Corker-Murphy bill would address the cash-strapped program by increasing the tax by 6 cents in each of the next two years and then index the rate to inflation. Besides the Corker-Murphy bill, Congress could tax drivers on how many miles they drive and communities could set up more tollbooths. Other potential long-term solutions are in the works but unlikely to pass this year.

Table one (click on image below) compares ten-year and thirty-year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.

With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.

Stupid as it has been for me to turn a critical eye onto the CPP Investment Board over the past seven years, there been some third party validation of late of much of the analysis and commentary that has me in the doghouse in certain quarters.

First, we had the Globe and Mail finally bearing down last month on some of the many topics and issues you’ve read about over the course of seven long years. Today’s validation comes via the Director of Private Equity at California State Teachers’ Retirement System as she weighs in, too; albeit indirectly. CalSTRS, with $189 billion under management, describes itself as “the largest educator-only pension fund in the world” and is very much a peer of Canada’s CPP in terms of size and asset allocation strategy.

CalSTRS has US$21 billion of private equity exposure; a smaller allocation than CPPIB’s $41 billion, but still chunky enough to give CalSTRS every reason to be transparent with its stakeholders about how that investment is doing, and where it is headed over the coming years.

Courtesy of a forthright interview with Buyouts Magazine, we can glean a frank assessment of how CPP’s (ie. our) mega buyout portfolio is doing too, since we share many of the same “2005-2008″ private equity fund commitments that CalSTRS invested in.

I know it’s not from our own fund managers, but here’s the news nonetheless, from Margot Wirth of CalSTRS (H/T again to Reuters):

- CalSTRS has a “very high exposure to those types of funds”, and will be reducing them going forward
- “Those vintages are not going to end up terrible” in terms of financial returns
- “2005 to 2008 account for 65 percent of the portfolio’s estimated $21 billion private-equity exposure”
- “many of those funds have performed poorly relative to benchmarks”
- CalSTRS “plans to put more emphasis on small and mid-market buyout, debt-related and emerging market funds”
- “Room for the pivot will be made by reducing the size of commitments to large buyout funds”
- CalSTRS “already has exposure to emerging managers and niche strategies through its $818 million Private Equity Proactive Portfolio. That program had been managed by a dedicated staff operating independently of the rest of the private equity team for most of the last decade. CalSTRS has spent the last year integrating that staff into its main private equity team, moving Proactive opportunities through the same due diligence process used for larger, more established managers.”

There you have it. As detailed and clear a discussion as a stakeholder could hope for about the state of the allocation and the plans for the near term. Via the media. Imagine what we’d learn if the Canadian scribes did a little less cheerleading and a bit more analysis about one of the largest buckets of investment capital the world over.

What we can deduce, according to CalSTRS, is that many of CPPIB’s 2005-2008 mega private equity commitments “have performed poorly relative to benchmarks.” Funds that Ms. Wirth is referring to likely include many of the big names, as these are PE vehicles that both CPP and CalSTRS are currently invested in (based upon public disclosure):

Apax Europe VII (2007), Apollo VI (2005), Apollo VII (2007), Blackstone Capital Partners V (2005), Blackstone Capital Partners VI (2008), CVC European Equity Partners V (2008), First Reserve Fund XI (2006), First Reserve Fund XII (2008), FountainVest China Growth Fund (2008), Hellman & Friedman Capital Partners VI (2006), Hellman & Friedman Capital Partners VII (2009), Hony Capital Fund 2008 (2008), Onex Partners III (2008):, Providence Equity Partners VI (2006), TPG Partners V (2006), TPG VI (2008), and Welsh, Carson, Anderson & Stowe X (2005).

We have billions and billions in these funds. Not that this is news to you, since you were well apprised as we went from allocating $1-$2 billion to external private equity funds to $8 billion per annum around the time that Mark Wiseman took over as SVP and Head of CPP Private Investments (see representative prior posts “Doubling Down on Private Equity at CPP Investment Board” Feb 20-09 and “61% of CPPIB Private Equity Commitments sampled are currently below solvency threshold” May 21-13). CalSTRS wasn’t the first big pension plan to make the point that we’d bought a bad batch, but they are definitely the first that I’ve seen who are actually investors in these particular funds. AIMCO’s CEO beat them to the punch, but CalSTRS deserves full credit for not mincing words (see prior post “AIMCo’s take on PE marks stark contrast to CPPIB” Aug 24-11).

Some will say that it isn’t Mr. Wiseman’s fault that 2005-08 turned out to be substandard vintage years for the mega buyout world. I agree, but the CPPIB’s team did dramatically increase our allocation — in both relative and absolute terms — to this asset class at absolutely the wrong time. Again, who knew? But the management and Board of Directors continue to refuse to provide clear disclosure about the true IRR financial performance of these funds, unlike CalSTRS, CalPERS, Oregon, WSIB and so forth (see prior representative post “CPPIB should take a page from Oregon’s book” Sept. 12-10). That can’t be blamed on back luck or third party LBO managers.

As for putting more of a focus on smaller and more diverse fund strategies, which is clearly underway at CalSTRS, CPPIB has been going the opposite way for as long as I can remember. This has always been a key concern of mine, as longstanding readers may recall. From 2007:

I cannot accept the argument that they are now “too big” to directly back Canadian VC funds. It takes just a few hours a year to monitor a fund once you’ve done the initial due diligence and made the commitment.

CalSTRS is making changes in how it interacts with smaller funds too, as they have taken steps to directly manage the “emerging manager”, small cap PE or VC universe, rather than outsource that to a Fund-of-Fund manager, ala CPPIB.

Most fascinating of all perhaps, is that CalSTRS is admitting to these concerns, and making immediate adjustments, despite turning in a return of 18.7% in its most recent fiscal year. Well ahead of CPPIB’s 16.5% number. Over a 10 year basis, CalSTRS’ return is 60 basis points higher than CPPIB’s (7.7% versus 7.1%); with that kind of enhanced performance, CPP could reduce payroll taxes for Canadian employers and workers, for example.

Sixty bps is quite the incremental value-add over an extended period. I can’t be sure if the premium performance directly leads to more transparency around how the assets are doing, but Canadians definitely benefit from the U.S. culture of complete disclosure from many of their pension stewards (see representative prior post “12 questions CPP Investment Board won’t be answering on BNN today” Jan. 17-13).

And for that we are grateful.

I cannot accept the argument that they are now “too big” to directly back Canadian VC funds. It takes just a few hours a year to monitor a fund once you’ve done the initial due diligence and made the commitment.

... I remember when I was working at PSP helping Derek Murphy set up private equity, I got him and Gordon Fyfe to meet Doug Leone, one of the founders of Sequoia Capital. In the VC world, Sequoia Capital are gods. They are part of a handful of elite VC funds and they command respect because they seeded Apple, Google, Oracle and many other successful technology powerhouses.

Anyways, I don't know where I got Doug Leone's name, probably from one of the many books I bought, but I just called him up and asked him if he would meet with Derek and Gordon. At first, he refused and told me straight out: "Don't bother investing in venture capital funds unless you want to lose all your money. We're not interested in meeting PSP or any public pension fund. Our last $500 million fund was oversubscribed by $4.5 billion. We're fighting amongst partners as to whether to allocate more money between Yale or Harvard's endowment fund. "

I kept pleading with him to meet Derek and Gordon. I even called him three times in one day until he finally gave in: "Ok kid, I like your persistence, tell them they got thirty minutes." Gordon and Derek loved that meeting and realized venture capital isn't a space PSP will ever invest in. They both told me "we never felt so poor in our lives." Of course, wealth is all relative as they're both doing just fine at PSP, collecting millions in comp beating their bogus benchmarks (they finally got the PE benchmark right!).

Most fascinating of all perhaps, is that CalSTRS is admitting to these concerns, and making immediate adjustments, despite turning in a return of 18.7% in its most recent fiscal year. Well ahead of CPPIB’s 16.5% number. Over a 10 year basis, CalSTRS’ return is 60 basis points higher than CPPIB’s (7.7% versus 7.1%); with that kind of enhanced performance, CPP could reduce payroll taxes for Canadian employers and workers, for example.

One other thing everyone does is talk up their successes in private markets but hide their miserable failures. I don't particularly like Mark McQueen, the guy who runs Wellington Financial mentioned in the article above, and think he has an agenda against CPPIB. But he's right that these large pension funds have had some serious flops in private markets and they all hide the bad news.

Why do they do it? It's all part of image and public relations. They want to get paid big bucks for managing billions from captive clients, even if in some cases this comp is totally unjustified, so they focus on highlighting their successes and hide their failures. The problem is these are public pension funds and they need to be a lot more transparent about their successes and failures in public and private markets (publish net IRRs of every single internal and external investment portfolio).

The Public Sector Pension Investment Board (PSP Investments) recorded an investment return of 16.3% for the fiscal year ended March 31, 2014.

The performance was driven primarily by strong results in public market equities as well as in the private equity, renewable resources, real estate and infrastructure portfolios.

The fiscal year 2014 investment return exceeded the policy portfolio return of 13.9%, representing $1.8 billion of value added over the benchmark return.

“Once again, performance was strong across the board with all investment teams contributing to value added over benchmark returns,” says John Valentini, interim president and CEO, and chief financial officer. “Most notably, from a performance perspective, we have outperformed the long-term rate of return objective used by the chief actuary by 0.9% per year over the past 10 years.”

Consolidated net assets reached a record $93.7 billion, an increase of $17.6 billion, or 23%, over the previous year. PSP Investments generated net investment income of $12.6 billion for fiscal year 2014 and received $5 billion in net contributions.

For fiscal year 2014, returns on public market equities ranged from 6.1% for the emerging market equity portfolio to 38.7% for the small cap equity portfolio. The fixed income portfolio generated a return of 4%, while the return for the world inflation-linked bonds portfolio was 6.9%.

In private markets, all asset classes posted solid investment returns for fiscal year 2014 led by private equity and renewable resources with returns of 24% and 20%, respectively. Real estate recorded a 12.2% investment return, while the infrastructure portfolio earned an investment return of 9.4%. The private asset returns reflect the currency hedging of these assets.

The asset mix as at March 31, 2014, was as follows: public market equities (52.8%), nominal fixed income and world inflation-linked bonds (17.7%), real estate (11.4%), private equity (9%), infrastructure (6.4%), cash and cash equivalents (1.9%) and renewable resources (0.8%).

The pension plan for federal government employees earned a 16.3-per-cent return last year, beating its investment benchmarks and pushing assets under management to almost $94-billion.

The Public Sector Pension Investment Board, which invests pension funds for federal civil servants including the Canadian Forces and the RCMP, said Thursday its assets climbed by $17.6-billion in the year ended March 31 – an increase from $76-billion last year – due to huge stock market returns and strong results in private equity and real estate holdings.

PSP Investments, Canada’s fifth-largest pension fund manager, said it earned $1.8-billion in value above its passive benchmark return of 13.9 per cent last year.

“Once again, performance was strong across the board with all investment teams contributing to value added over benchmark returns,” said interim chief executive John Valentini.

Mr. Valentini was appointed in June following the resignation of former CEO Gordon Fyfe, who left to head B.C.’s pension fund manager, British Columbia Investment Management Corp.

Mr. Valentini said PSP has outperformed the long-term return target it needs to hit to meet its projected pension obligations.

On a 10-year basis, the fund has earned an average annualized return of 7 per cent, which translates into a return of 5.2 per cent after inflation is taking into consideration. The Chief Actuary of Canada said federal pension plans needed to achieve an average return of 4.3 per cent after inflation over the past decade.

Like many pension funds, PSP’s returns in the past year easily topped gains in other recent periods due to steep improvements in stock market returns. The fund’s 16.3-per-cent gain in fiscal 2014 exceeded gains of 10.7 per cent in 2013 and 3 per cent in 2012.

The fund said gains from its public market stock portfolio ranged from 6.1 per cent in emerging markets to 38.7 per cent for its small cap equity portfolio. Private equity investments climbed 24 per cent last year, while renewable resource holdings were up 20 per cent and real estate climbed by 12.2 per cent.

The fund said it holds just over half its assets – 53 per cent in public market equities – while fixed income and bond investments total just 17.7 per cent of its assets. The remainder of its holdings are in real estate, private equity, infrastructure, renewable resources and cash.

The most critical component with respect to the strategic Goal No. 1, Portfolio Management, is the Policy Portfolio, which essentially stipulates how every dollar transferred to PSP Investments is allocated to asset classes. A key Board responsibility, the Policy Portfolio is reviewed annually. The review focuses on the liability structure under the pension plans and examines the appropriateness of the Policy Portfolio to meet these liabilities. This examination includes a major focus on PSP Investments’ long-term capital market assumptions and related methodologies, which are key inputs in the design of the Policy Portfolio. Enhanced scenario testing has been undertaken to validate potential outcomes.

Consideration was given during fiscal year 2014 to adding or expanding asset classes. However, we concluded that the current Policy Portfolio, with its target of 42% Private Markets investments, remains effective and should enable PSP Investments to meet or exceed its long-term rate-of-return objective (4.1% after inflation), with an acceptable level of risk. Supporting this conclusion is the fact that, over 10 years, PSP Investments has outperformed the return objective by 0.9% per year. This excess return per year translates into a cumulative $7.7 billion of investment gains when taking into account the size and timing of cash inflows.

Finally, with regard to strategy, in light of PSP Investments’ increasingly global reach — with more than half our assets now invested in foreign markets— consideration was given to the desirability of opening offices in markets outside Canada. Upon reflection, the Board and senior management concurred that we continue to be well served by our current strategy, which entails working closely with select local partners to identify attractive potential investments abroad,while maintaining the organizational agility to respond quickly to such opportunities.

• At year’s end more than $70 billion or 75% of consolidated net assets was being managed internally. Some $38 billion of that amount was actively managed by our own teams — representing an increase of 31% from the previous year-end. This contrasts sharply with the situation back in fiscal year 2004, when only $1.7 billion of assets were being actively managed in-house. While actively managing many of our own portfolios involved building the requisite high-calibre teams, it has enabled us to realize significant savings estimated at between $180 million and $265 million in fiscal year 2014 alone. Thanks in large part to the internal active management strategy, PSP Investments’ cost ratio has been trending downwards in recent years and compares favourably with peers in the Canadian pension investment industry. Moreover, results indicate that our internal investment managers have in many instances been significantly outperforming our externally-managed investments.
• Notwithstanding the increased emphasis on internal management, PSP Investments continues to forge strong relationships with select partners, including other leading pension investment managers...By way of example, it was thanks to our strong relationship with a prominent fund in the Asia-Pacific region that the Private Equity team was able to acquire a significant equity interest in a leading Asian life insurer during the latest fiscal year. With some $21 billion in assets, ING Life Korea is that country’s fifth-largest life insurance company. This investment fits well with PSP Investments’ aim of expanding its holdings in developing economies. In line with our increased focus on direct and co-investments, the Private Equity team also divested approximately $US1.3 billion of private equity funds during the year through a competitive auction process.
• Other noteworthy transactions during fiscal year 2014 included the Infrastructure team’s purchase of AviAlliance GmbH (formerly Hochtief AirPort GmbH), an airport investment and management company. AviAlliance held interests in the airports of Athens, Budapest, Dusseldorf, Hamburg, Sydney and Tirana which, combined, handle approximately 95 million passengers annually. The complexity of the transaction gave PSP Investments a competitive advantage to acquire an attractive portfolio of airports with long-term growth perspectives.
• It was another deal-intensive year for our Real Estate team, which completed the sale of its Canadian Westin hotel portfolio — one of PSP Investments’ first major real estate investments. The transaction generated solid annualized returns of close to 15% over eight years. As well, Revera Inc., PSP Investments’ largest Private Markets holding, sold a 75% interest in a sizeable portfolio of Canadian retirement properties, thereby reducing PSP Investments’ exposure while allying Revera with a credible strategic partner. Significant Real Estate acquisitions included a 50% stake in 1250 René-Lévesque, a million-square-foot-plus Class A office tower in downtown Montreal that houses the main business offices of PSP Investments; and the purchase with several partners of a large office property strategically situated on Park Avenue in Manhattan. We also created a $1.5-billion (€1-billion) logistics joint-venture with London-based SEGRO, a leading industrial/warehousing property owner, manager and developer listed on the London Exchange. The joint venture involves 34 estates in Western and Central Europe, totaling more than 17 million square feet.
• Our Renewable Resources team formed a strategic agricultural joint venture with an established farmland investor and manager in Latin America, which will serve as PSP Investments’ platform for the further acquisition, development and management of farmland in the region. Again, this transaction is consistent with PSP Investments’ strategy to partner with best-in-class investors and operators in key regions.
• We have made significant investments to build a robust technology and data-management infrastructure to support our rapid growth. We continue to strengthen our capabilities in that respect, focusing on the implementation of scalable systems that can effectively handle public and private market transactions from end to end. As PSP Investments’ portfolios continue to expand, these systems also allow for enhanced monitoring, reporting, analysis and risk management.
• The solid results we posted for fiscal year 2014 reflect PSP Investments’ exceptional bench strength. The team we have built in Montreal is the equal of any similar-sized pension investment organization anywhere in the world. In that regard, I would suggest our performance speaks for itself. But you need not take my word for it: in the course of my frequent travels to meet with people around the globe with whom we do business, it is gratifying to hear the near universal respect and high regard our partners express for the men and women of PSP Investments with whom they deal. The calibre of our team reflects our uncompromising efforts to identify, attract, retain and develop top-flight talent.

• First, in Public Markets, the performance was pretty much benchmark in bonds and stocks. PSP indexes their Canadian stock portfolio and bonds but I noted strong outperformance in their EAFE Large Cap Equity portfolio in FY 2014 (28.3% vs 27.7%) and over the last four fiscal years (10.7% vs 10.3%). Importantly, this was the only portfolio in Public Markets with significant outperformance over the last fiscal year and last four fiscal years (bravo to Jérôme Bichut and his team!).
• One thing that struck me in Public Markets was the significant under-performance of U.S. Large Cap Equity in  FY 2014, returning 29.5% vs its benchmark return of 32.4% (an almost 300 basis points miss in U.S. large caps is crazy). Emerging Markets Equity also under-performed its benchmark by 100 basis points (6.1% vs 7.1%).
• In Private Markets, there was significant outperformance in FY 2014 in Private Equity (24% vs 14.7%), Real Estate (12.2% vs 5.2%), Infrastructure (9.4% vs 4.6%) and Renewable Resources (20% vs 5%). 
• Over the last four fiscal years, the bulk of the value added that PSP generated over its (benchmark) Policy Portfolio has come from two asset classes: private equity and real estate. The former gained 16.9% vs 13.7% benchmark return while the latter gained 12.6% vs 5.9% benchmark over the last four fiscal years.

• The total incentive amount paid under the STIP was $36.5 million in fiscal year 2014 (465 employees), $29.9 million in fiscal year 2013 (404 employees) and $23.1 million in fiscal year 2012 (362 employees).
• The total incentive amount paid under the LTIP was $17.5 million in fiscal year 2014 (73 employees), $15.2 million in fiscal year 2013 (55 employees) and $6.7 million in fiscal year 2012 (42 employees).

Could the disaster that fell upon Malaysia Airlines flight MH17 trigger a major global war after dozens of innocent lives, who definitely had nothing to do with the tensions ongoing between Ukraine and Russia, were lost?

Leaders from Malaysia, Australia, New Zealand, the UN and the U.S. have called for a full-blown investigation in the disastrous accident even as US intelligence authorities said a surface-to-air missile was what downed the Malaysia Airlines flight MH17 commercial passenger jet.

"There is clearly a need for a full and transparent international investigation," UN Secretary-General Ban Ki-moon said.

Suffice to say, the U.S. may consider this unfortunate event as the time it has to step in and take aggressive action to stop the fighting in Ukraine.

U.S. President Obama could be forced to send more advanced arms to Ukraine's security forces, as well as train them. "This will undermine the case of those who have been reluctant," an unidentified U.S. official told Reuters.

What happened on Thursday, the official said, "could go two ways." It could make countries pause and review the seemingly escalating danger of the Ukraine conflict, or force them to join into the fray and "put their heads in the sand."

European flight safety body Eurocontrol on Thursday said it had received an advisory from Ukrainian authorities declaring the country's east portion as a no-fly zone after a Malaysian airliner with 295 onboard crashed in the region.

An intercepted series of phone conversations between Russian separatists said Malaysia Airlines flight MH17 has no business flying over Ukrainian airspace, unless it was carrying spies.

Eurocontrol had explained that while Ukrainian authorities had closed the route from ground to flight level 320, the doomed Malaysia Airlines flight MH17 was flying at Flight Level 330 (approximately 10,000 metres/33,000 feet) when it disappeared from the radar. The level at which the aircraft was flying was therefore open, it added.

It was believed pilots of the doomed Malaysia Airlines flight MH17 opted to fly above Ukraine airspace to save on fuel.

"Flights over troubled regions are very common," Dave Powell, dean of Western Michigan University's College of Aviation and a retired Boeing 777 captain at United Airlines, told International Business Times U.S. "Both governments and airlines take a look at the threats out there, of course. But when you're trying to save money and competing against everyone else, my guess is, everybody is doing that kind of routing."

Eurocontrol said that since the crash, Ukrainian airspace is now closed from the ground to unlimited (altitude) in Eastern Ukraine.

"The routes will remain closed until further notice."

Lange, 59, was among what is thought to be dozens of AIDS researchers, consultants and policy experts headed from the Netherlands to Malaysia and onward to an international AIDS conference in Australia when their Boeing 777 plane appeared to have been blown out of the sky Thursday over the battlefields of eastern Ukraine's separatist insurgency.

The always-predictable mainstream media are now calling for even-more punishing sanctions on Russia. The evening of the incident, The Washington Post scolded the White House for continuing to “avoid measures that could inflict crushing damage on the Russian financial system and force Mr. Putin and the elites around him to choose between aggression in Ukraine and Russia’s economic future.”

Leaving aside the rather elementary fact that sanctions hardly ever change the behavior of the regimes at which they are aimed, consider this counterfactual: What if Mr. Obama had not announced a new round of sanctions against Russia on July 16? It is entirely possible that the murderous recklessness of the pro-Russian forces would have given Mr. Putin sufficient cover from his increasingly vocal right flank—who have been calling for greater Russian involvement, if not an outright invasion—to break with the rebels. What the July 16 sanctions announcement has done is effectively block the off-ramp. Yet the idea that sanctions may be counterproductive never seems to dawn on our establishment elites. Meanwhile the war hawks in Congress are eagerly chomping at the bit to retaliate, with their leader, Senator John McCain, promising there would “be hell to pay” if the Malaysian airliner was shot down by the Russian military or separatists.

One can’t help but wonder: hasn’t there been hell enough?

MH17 is an alarming escalation of the Ukraine conflict. In the wake of a surface-to-air missile taking down a Malaysian airliner over Eastern Ukraine, everyone is pointing fingers. Kiev blames the pro-Russian “terrorists,” with Moscow responsible for providing them with intelligence and weapons. The separatists deny involvement and accuse Kiev of planning the attack, citing the Ukrainian military’s accidental shooting of a Siberian Airlines flight in 2001. Moscow blames the Ukrainian government for pushing the rebels into this violent situation — even if Russian President Vladimir Putin stopped short of pinning the airliner attack on Kiev. Despite the confusion, it’s clear what MH17 means: dramatic escalation and an even more combustible conflict.

Some analysts and pundits are viewing the downed flight as an opportunity to force Putin into tempering his support for the separatists. While clearer proof of pro-Russian separatist guilt does, in principle, provide the Russians with a reason to do so, it’s highly unlikely that Russia will seize the chance. The underlying fissures have not gone away — in fact, MH17 makes them even more pronounced.

Putin continues to view his country’s influence over Ukraine and the power to keep it from joining NATO as a national security interest of the highest order — the same way Israel wants to deter Iran from obtaining a nuclear weapon. Recent events haven’t shifted Putin’s interests in the slightest. In fact, the three biggest changes coming out of the MH17 crash point to more escalation. First, Putin’s statements blaming the Ukrainians will be exceedingly difficult to back away from. It’s not yet clear whether Russia will accept that separatists shot down the plane or instead deny, obfuscate and even refute the evidence. But either way, Moscow will maintain its claim that the Ukrainian government is responsible for driving the violence and destabilising the region where the plane crashed. Moscow will leverage its state media to promote this message.

Second, with proof that pro-Russian separatists are to blame, we will see a material ramp-up in sanctions from both Europe and the United States — and on an accelerated schedule. German Chancellor Angela Merkel is out in front of the story, declaring early Friday that “Russia is responsible for what is happening in Ukraine at the moment.” Meanwhile, the United States would forge ahead, broadening financial, energy and possibly other sector sanctions against Russia. These increases will amount to an escalation, rather than a redirection, of the conflict. The sanctions would have a real impact on Russia’s economy and investor sentiment — existing sanctions already do — but it’s highly unlikely that they would shift Putin’s calculus in Ukraine.

Lastly, MH17 gives Ukrainian President Petro Poroshenko more robust international support and more sympathy for his military campaign against the separatists, which has been moderately successful over the past few weeks. Now that he’s claimed that the “terrorists” are behind the attack, he has a responsibility to crack down on them further. He’ll likely make a more concerted push into rebel strongholds Donetsk and Luhansk. But this is going to be a bloody and uphill struggle — MH17 won’t change much on the battlefield, where urban house-to-house fighting will not proceed as cleanly as Poroshenko’s previous operations. We’re most likely heading to a standoff, amidst prolonged violence and shorter tempers on all sides. The downing of MH17 is not as much a sharp turn in the Ukraine conflict as it is an acceleration — shining an international spotlight on this deepening crisis.

Institutional investors increasingly are translating co-investment experience in private equity, real estate, infrastructure and energy funds to their hedge fund portfolios.

Co-investment with hedge fund managers is growing, if a bit slowly, especially with credit and activist equity managers as institutions become more comfortable with an even more direct type of hedge fund investing.

Appetite is growing: 52% overall of investors surveyed by J.P. Morgan Capital Introduction Group for its 2014 Institutional Investors Survey said they were willing to participate in hedge fund co-investments.

A breakdown of respondents showed 74% of endowments and foundations would co-invest with hedge funds, followed by 68% of consultants; pension funds, 60%; family offices, 59%; and insurance companies and hedge funds of funds, both 46%.

Despite this professed interest, the overall pace of pension funds, endowments, foundations and sovereign wealth funds in hedge fund co-investments has been a tad slow, sources said.

“This is a good investment space, but there are a significant percentage of institutional investors that are too boxy to be comfortable with co-investing,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“You have to be flexible to take advantage of co-investing because it does fall into the cracks between asset classes,” Mr. Nesbitt added.

“The interest level in co-investments is about the same as a year ago, but the difference is that institutional investors had a desire to see co-investment ideas but not to invest,” said Richard d'Albert, principal, co-chief investment officer and portfolio manager at credit specialist hedge fund manager Seer Capital Management LP, New York.

“The credibility factor has risen and now the conversations are turning more often to investment,” Mr. d'Albert said.

Seer Capital has set up co-investment vehicles with a handful of larger clients, Mr. d'Albert said, noting the firm's hedge funds “get first dibs on any of our investment ideas, but sometimes we do run across an outsized opportunity that has great potential, but is too big to accommodate in our funds.”

Seer Capital managed $2.2 billion in structured credit hedge fund approaches as of June 30.

Hedge fund managers offering occasional one-off co-investment opportunities or permanent, dedicated co-investment funds are grouped within event-driven equity and fixed-income approaches, as well as specialists who invest in structured products, lending, mortgage- and asset-backed securities and more esoteric credit investments, such as Iceland bank debt.

In addition to Seer Capital, among those managers attracting institutional investor interest in their co-investment funds are JANA Partners LP, Pine River Capital Management LP, Solus Alternative Asset Management LP, Starboard Value LP and Taconic Capital Advisors LP.

New niche

One reason for the slow buildup in hedge fund co-investment is the relative newness of the niche. Institutions have been co-investing with private equity and real estate managers for more than two decades. But hedge fund managers, for the most part, only shifted to co-investment since the 2008 financial crisis.

Before the crisis, hedge fund managers routinely segregated less liquid assets in separate “side-pocket” funds they ran alongside their flagship commingled funds. The crisis made it extremely difficult to divest those illiquid investments and, rather than sell assets at fire sale prices, hedge fund managers shut redemption gates, locking up investor assets for years.

Mr. Nesbitt said hedge fund managers have begun to recapture the institutional market by repackaging their best, most concentrated investment ideas into vehicles with “much better terms,” including lower fees, lower carry, fees charged only on invested capital and “very attractive performance.”

“Performance comparison of the hedge fund co-investment niche is impossible,” said Jon Hansen, managing director-hedge funds for C/A Capital Management, Boston, the investment outsourcing money management subsidiary of consultant Cambridge Associates LLC.

“There's no way to give a range of returns for hedge fund co-investments because performance is so dependent on unique, individual underlying deals,” Mr. Hansen said.

But the returns of individual co-investments, rarely revealed publicly by hedge fund managers or their large investors, will propel more institutions to seek a place in the investment queue, sources predicted.

“Hedge fund co-investment will evolve from the minority sport that it is today into a defining feature of risk capital markets in the future,” wrote Simon Ruddick, CEO and managing director of alternative investment consultant Albourne Partners Ltd., London, in an e-mail.

"Nimbleness and flexibility'

“Hedge fund co-investments embody the nimbleness and flexibility required to give hedge fund managers, and their investors, an essential edge in the ever more competitive quest for alpha. We see hedge fund co-investment as a core component of a larger phenomenon: customized investments,” Mr. Ruddick wrote.

One early example of the type of customization institutional investors are doing with their hedge fund managers is the New Jersey Division of Investment's $300 million investment in February with credit hedge fund manager Solus Alternative Asset Management.

The investment division, based in Trenton, manages investments for the $78.6 billion New Jersey Pension Fund.

Solus' credit mandate specifies flexibility, allowing the firm to invest up to two-thirds of the allocation in its flagship opportunistic event-driven and special situations credit strategy and up to two-thirds in “recovery-like opportunities, including ... high-conviction co-investment opportunities,” according to a report from Christopher McDonough, director of investments, at the Feb. 3 State Investment Council meeting. The council advises the investment division on pension fund management.

Mr. McDonough was unavailable to comment about the division's rationale behind the Solus investment, said Christopher J. Santarelli, a spokesman for the New Jersey Treasury Department, which oversees the Division of Investment.

The Solus investment was not New Jersey's first to a hedge fund co-investment. In May 2013, JANA Partners was awarded $100 million for investment in its flagship Strategic Investments Fund, which invests about 30% of its assets in shareholder activist opportunities. New Jersey also committed $200 million to co-investing with JANA in activist shareholder deals.

Randall W. Forsyth of Barron's reports, Pension Funds Should Take Care What They Wish for:

U.S. corporate pension funds are in the best shape they've been in since before the 2008 financial crisis as their shortfalls were cut nearly in half in 2013. Credit surely goes to the rising stock market, but last year's improvement in the funds' positions also owed much to the rise in bond yields.

Indeed, fully closing the gap between pension funds' assets and their future liabilities may depend more on higher interest rates than continued gains in the stock market.

Corporate pension plans among the Standard & Poor's 500 companies were last fully funded in 2007, before the financial near-meltdown of the following year. From 2009 to 2012, the plans' underfunding ranged between 16% and 23% -- with the worst shortfall in 2012, when S&P 500 index already had made a huge recovery from its recession lows.

These data cover the traditional, defined-benefit plans that were the norm for Corporate America a generation ago. As S&P Credit Week observes, U.S. companies have dealt with the burden of pension costs by shifting it to employees with defined-contribution plans such as 401(k) plans. The result: 46% of workers had saved $10,000 or less for retirement while an additional 20% had socked away between $10,000 and $49,900, according to a 2013 study by the Employee Benefit Research Institute. Only half of all workers receive any retirement benefits from their employers.

For those lucky enough to look forward to a monthly check in retirement, their employers have to set aside and invest funds to meet those obligations. Among the S&P 500 companies, 51 were fully funded at the end of 2013, up from just 18 in 2012.

The list of the most under-funded defined-benefit plans were dominated by old-line manufacturing companies, notes Tobias Levkovich, Citi Research's chief investment strategist. Leading that less-august list were General Motors (ticker: GM ), ExxonMobil ( XOM ), Boeing ( BA ), Ford Motor (F), DuPont ( DD ), Pfizer ( PFE ) and Caterpillar ( CAT. ) And that was after the 30% surge in the S&P 500 last year.

There was another, less obvious boost to corporate pension plans in 2013: higher bond yields. Given that the jump in yields, which took the benchmark 10-year Treasury to 3% from a low of about 1.65%, resulted in bond price declines and negative returns from investment-grade debt last year, that might seem counterintuitive.

But the higher yields lowered the present value of future pension fund liabilities. (A higher discount rate for a stream of future payments lowers that stream's discounted present value. At a higher interest rate, it's possible to set aside a smaller sum to meet a future savings goal, and vice versa.) The discount rate on pension funds' liabilities, which is based on the yield from investment-grade corporate bonds, rose in 2013 to 4.69% from 3.93% in 2012.

The impact on interest rates is apparent from the experience of the two preceding years. According to S&P, despite 2012's 13.4% equity return, pension underfunding among the S&P 500 companies actually increased over 27%, to an aggregate $451.7 billion from $354.7 billion, owing to the decline in interest rate and the resulting increase in the present value of future liabilities. And while the 29.6% gain in the S&P 500 index in 2013 helped reduce underfunding by over 50%, to $224.5 billion, the increase in the discount rate on future liabilities "assisted considerably," S&P observed.

While 2014 is only a bit more than half over, the trends are less positive than last year's. The S&P 500 is up 7.5%, setting another record Wednesday. But contrary to expectations of virtually every forecaster, bond yields have fallen markedly this year, to 2.47% on the Treasury 10-year note as of Wednesday, a hair above the 2014 low of 2.44%.

The gain in the S&P 500 and the fall in bond yields suggest a rerun of 2012's experience, when pension fund underfunding increased despite positive equity and debt market returns.

To be sure, writes Citi's Levkovich, "the stock market is crucial to the asset side of pension story." But given the likelihood of "modest single-digit gains through mid-2015, it will not close the gap entirely."

"The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the time line of fully funded status," he concludes.

S&P agrees, but it also avers while higher interest rates would drastically improve the funding of corporate pensions, they would also be potentially damaging to parts of the economy.

Indeed, it is difficult to reconcile pension plans' hope for higher stocks and higher bond yields. Low interest rates without a doubt have increased price-earnings multiples as low yields have lured investors into equities. Low interest rates also have provided an important lift to corporate profits as well by sharply reducing interest costs, while stock buybacks have boosted earnings per share for public corporations. The bottom lines of financial companies such as banks also have benefitted from the reduction in loan-loss reserves, which have flowed directly to the bottom line of the S&P 500.

Thus, Corporate America -- or at least the portion that still offer pension plans -- would like higher interest rates to reduce their future liabilities to retirees. But the impact on the economy and the stock market likely would be negative.

Another reason to heed the admonition to be careful what you wish for.

Take the time to read my recent comment on when interest rates rise where I wrote:

A rise in interest rates will benefit pension plans (discount rate rises, lowering the net present value of liabilities) and savers but it will crush many debt-laden consumers and businesses struggling to stay afloat and will lead to a full-blown emerging markets crisis, which is very deflationary.

So should pensions be careful for what they wish for? It all depends on how dramatic the rise in interest rates will be. If interest rates spike up, it will hurt pensions on the asset front real hard but it will significantly lower the liabilities those pensions pay out.

Here we have to introduce the concept of duration. It's important to understand the duration of liabilities are a lot longer than the duration of assets. This means that when interests rates are low, a fall in rates will disproportionately impact liabilities a lot more than it impacts assets. In other words, in a low rate environment, when rates fall, liabilities go up more dramatically than the rise in the value of assets.

This is why many corporations are scrapping defined-benefit plans and replacing them with 401 (k) (RRSP) type plans which effectively places the onus entirely on individuals to make wise investment decisions to retire in dignity. If a bear market strikes them, too bad, they're left fending for themselves.

The problem nowadays is rates keep falling. My former colleague, Brian Romanchuk notes the bond bear market of 2014 has been delayed:

Strategists went into 2014 with a consensus bearish view on bonds (as was also the case in 2010-2013...). The market action so far has not been kind to that view, with yields plunging in the developed markets. It may be that I have fallen into a too mellow summertime mood, but my guess is that this is largely a squeeze of the bond bears during quiet markets (although there are obvious geopolitical concerns).

The JGB market has not been cooperating with those who have been calling for collapse and hyperinflation; rather yields have marched from stupidly expensive to insanely expensive levels. At a 0.54% yield, the 10-year JGB is at a very interesting position. As I have pointed out before (when yield levels were slightly higher...), the payoff on an outright short position which can be held for a considerable period looks attractively asymmetric (click on image above).

It's A Forward Story

What is interesting about the rally in the U.S. Treasury market is that it a story about the forwards. My crude proxy of the 5-year rate, 5-years forward has been marching steadily lower since peaking around New Year's. Meanwhile, the spot 5-year rate has been tracking sideways (click on image above). Therefore, the rally has not been about revising the timing of rate hikes, rather it is a downward revision of "steady state" interest rates. This could be explained by a number of factors:

• Quantitative Easing (why now?);
• belief in Fed jawboning future rates;
• forward rate expectations slowly adapting to lower realised rates;
• demand for duration by liability-matching investors.

Although I believe that long-term rate expectations needed to be revised lower from the 5% average that held before 2012 as a result of the demand for duration, 3¼% may be too far. In any event, there is unlikely to be clarity until market liquidity comes back in September.

What else explains this move in the yield curve? In a recent comment, I discuss how Japan's private pensions are eying more risk, snapping up corporate bonds, REITs, leveraged loans and U.S. bonds. And they're not the only ones. Other countries facing low yields are also looking at U.S. bonds because of the spread (see Hoisington's second quarter economic letter).

By far, the largest purchaser of U.S. Treasuries after the Fed is China (click on image below):

Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China.

The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago, data released Wednesday show. The purchases help explain Treasurys' unexpectedly strong rally this year. The yield on the 10-year U.S. Treasury note has fallen to 2.54%, from 3% at the end of 2013. Yields fall as prices rise.

The world's most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014, according to the U.S. government data. The buying has been fueled by China's efforts to lift its export-driven economy by weakening its currency, the yuan, against the dollar, market analysts said, a strategy that encompasses hefty purchases of U.S. assets.

China officially holds roughly $1.27 trillion of U.S. debt, about 10.6% of the $12 trillion U.S. Treasury market.

The country's purchases have salutary effects on both sides of the Pacific. In addition to the weaker yuan in China, they hold down U.S. interest rates, making houses more affordable and generally easing financial conditions in the U.S. economy.

On the other hand, lower yields mean lower income for bond investors. They have spurred investors to chase assets globally for returns, fueling asset-price increases and investor fears that some market valuations are stretched.

Also, investors fear any reduction in Chinese purchases, along with other macroeconomic events, could destabilize the U.S. bond market and send rates higher, slowing the housing industry, widely viewed as a key driver of economic growth. Some analysts contend that low rates also can allow capital to be misallocated, fueling the risk of future economic disruption.

In a bid to boost returns, China has sought to diversify its foreign-exchange holdings away from U.S. government bonds in recent years. But it finds itself having to keep purchasing the U.S. debt due to a lack of investment choices elsewhere. "There is no other market that is as liquid and deep as the U.S. Treasury market," an official at China's central bank said in a recent interview.

China's aggressive purchases of dollar assets also present the authorities with problems at home. That is because the purchases cause the money supply to expand and can fuel inflation within China unless the central bank soaks up the excess liquidity injected into the system.

The bond rally has left many traders on Wall Street scratching their heads. Most investors had forecast that interest rates would rise this year as the U.S. economy picked up steam and the Federal Reserve slowly pared its stimulus measures, in a shift that was widely expected to push rates higher.

But yields remain far below 2013 highs even as U.S. job creation has gained pace in recent months. The disclosure of China's holdings underscores the frayed nerves in the bond market as the Fed prepares to raise interest rates as early as next year, for the first time since the financial crisis. Many investors fear that reduced Fed support and unpredictable buying by foreign governments could spell bond-market tumult.

"The big picture is that China buying may be helping to keep bond yields lower than they should be ahead of the Fed moving closer to raising rates," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "The market could wake up and get quite a shock…if China changes course." The risk for the U.S. economy, said Mr. Rupkey, is that any slowdown in Chinese purchases could push U.S. bond and mortgage rates higher, which would put "the fragile housing recovery in jeopardy."

At the same time, many investors over the past decade have warned of the risks of reduced purchases from China precipitating a U.S. interest-rate spike—predictions that haven't been borne out.

The rise in China's Treasury holdings disclosed Wednesday marks the biggest first-five-month increase since record keeping began in 1977 and surpasses the $81 billion of Treasury debt bought by China for all of 2013, according to Ian Lyngen, senior government-bond strategist at CRT Capital Group LLC.

China has increased its U.S. Treasury holdings every year since the 2008 financial crisis except for 2011. China continued to log a trade surplus with the U.S., thanks to its aggressive efforts to boost exports over the past decade. That has led to a huge accumulation of foreign-exchange reserves, and the Treasury market is the most liquid bond market for China to invest reserves, analysts said.

China held $1.2633 trillion in notes and bonds at the end of May, compared with $1.156 trillion at the end of 2013, according to Jeffrey Young, U.S. rates strategist at Nomura Securities International in New York.

The gain reflects in part China's decision to shift its U.S. investments to longer-term securities from short-term debt known as bills. Including bills, which mature in a year or less, China held $1.2709 trillion of Treasury debt at the end of May, compared with $1.2700 trillion at the end of December 2013, according to the latest data from the Treasury Department.

Analysts have long cautioned that the Treasury report isn't a complete picture because it doesn't account for China's holdings at third-party custody institutions in other nations, such as the U.K. and Belgium.

China's foreign-exchange regulator, the State Administration of Foreign Exchange, didn't immediately respond to a faxed request for comment.

China's purchases come as U.S. issuance slows, amid higher tax receipts from an improving economy. Mr. Young at Nomura Securities International estimated that net supply of Treasury notes and bonds this year would be $650 billion to $690 billion, down from $836 billion last year and $1.565 trillion in 2010.

The Fed has been dialing back its monthly purchases as well. Mr. Young said the central bank's buying this year would account for about 38.5% of net Treasury issuance, down from 65% last year.

China hasn't been the only big buyer this year. Japan, the second-largest foreign owner of Treasury bonds, increased its note and bondholdings by $9.56 billion during the first five months of the year. Including bills, Japan's holdings of Treasury debt was $1.2201 trillion.

China's foreign-exchange reserves currently approach $4 trillion, the world's biggest in size. China doesn't disclose the composition of the reserves, but analysts say most are denominated in U.S. dollars. This year, China has taken actions to weaken its local currency to make its exports cheaper. When China sold the yuan, it bought the U.S. dollar, and analysts said China likely often used the proceeds to purchase more Treasury debt.

"China will continue to buy Treasury bonds as long as they want to keep the yuan's value lower to support exports," said Peter Morici, professor at the Robert H. Smith School of Business at the University of Maryland. "I don't think China will pull away from the Treasury bond market even if the Fed raises interest rates."

Christopher Sullivan, who oversees $2.35 billion as chief investment officer at the United Nations Federal Credit Union in New York, added that "China's investment in Treasury bonds is mostly trade driven and not opportunistic," like hedge funds or other bond traders.

U.S. bonds yield more than Germany's, which are at 1.2%, and Japan's, at 0.54%. Strategists at Goldman Sachs Group Inc., J.P. Morgan Chase& Co. and Morgan Stanley expect the 10-year Treasury yield to rise to 3% by the end of 2014. Goldman recently cut its year-end forecast from 3.25%.

Some investors caution that higher-yield forecasts may not pan out. China's buying will be "a restraint on yields,'' said Mr. Sullivan. "I think 3% is highly suspect for 2014."

If one believes that US growth will accelerate, that current high level of geopolitical risk will diminish, and that the Rising Inflation scenario will prevail, my preference at mid-year would still be the conservative 45% Equity, 25% Bond, 30% Cash portfolio. The evolving, highly uncertain environment still argues for a cautious and flexible approach.

As states and cities grapple with budget shortfalls, many are betting big on an unproven formula: Slash public employee pension benefits and public services while diverting the savings into lucrative subsidies for professional sports teams.

Detroit this week became the most prominent example of this trend. Officials in the financially devastated city announced that their plan to slash public workers’ pension benefits will move forward. On the same day, the billionaire owners of the Detroit Red Wings, the Ilitch family, unveiled details of an already approved taxpayer-financed stadium for the professional hockey team.

Many Detroit retirees now face big cuts to their previously negotiated retirement benefits. At the same time, the public is on the hook for $283 million toward the new stadium.

The budget maneuvers in Michigan are part of a larger trend across the country. As Pacific Standard reports, “Over the past 20 years, 101 new sports facilities have opened in the United States — a 90 percent replacement rate — and almost all of them have received direct public funding.” Now, many of those subsidies are being effectively financed by the savings accrued from pension benefit reductions and cuts to public services.

In Chicago, for instance, Mayor Rahm Emanuel recently passed a $55 million cut to municipal workers’ pensions. At the same time, he has promoted a plan to spend $55 million of taxpayer money on a hotel project that is part of a stadium development plan.

In Miami, Bloomberg News reports that the city “approved a $19 million subsidy for (a) professional basketball arena” and then, six weeks later, “began considering a plan to cut as many as 700 (librarian) positions, including a fifth of the library staff and more than 300 police.”

In Arizona, the Phoenix Business Journal reports that regional governments in that state have spent $1.5 billion “on sports stadiums, arenas and pro teams” since the mid-1990s. Meanwhile, legislators are considering proposals to cut public pension benefits.

In New Jersey, Gov. Chris Christie is blocking a planned $2.4 billion payment to the pension system, at the same time his administration has spent a record $4 billion on subsidies and tax breaks to corporations. That includes an $82 million subsidy for a practice facility for the Philadelphia 76ers.

The officials promoting these twin policies argue that boosting stadium development effectively promotes economic growth. But many calculations rely on questionable assumptions.

In a 2008 data review by University of Maryland and University of Alberta, researchers found that “sports subsidies cannot be justified on the grounds of local economic development.” In addition, a 2012 Bloomberg News analysis found that taxpayers have lost $4 billion on such subsidies since the mid-1980s.

“Sports stadiums typically aren’t a good tool for economic development,” said Holy Cross economist Victor Matheson in an interview with The Atlantic. “Take whatever number the sports promoter says, take it and move the decimal one place to the left. Divide it by ten, and that’s a pretty good estimate of the actual economic impact.”

Of course, while stadium subsidies are promoted in the name of economic development, pension benefits are rarely described in such terms – even though the data suggests they should be. Indeed, an analysis by the Washington, D.C.-based National Institute on Retirement Security notes that spending resulting from pension payments had “a total economic impact of more than $941.2 billion” and “supported more than 6.1 million American jobs” in 2012.

Despite that, retirement benefits are often the first item on politicians’ chopping blocks. Pensions, after all, may support local economies, but they don’t result in shiny new stadiums.

In a sports-obsessed country, that makes those pensions a much bigger political target than any taxpayer handout to a billionaire team owner.

Detroit's bankruptcy plan approached a new stage Monday after city pension holders endorsed a debt-cutting plan that would dent, but not decimate, their future benefits.

General retirees, who comprise the bulk of those affected, would get a 4.5% pension cut and lose cost-of-living increases. Retired police officers and firefighters would surrender part of their annual cost-of-living increases.

Contingent on the vote was an agreement by the state and private funders to make $816 million available to shore up pensions. That amount represents the present value of the city's world-class collection of the Detroit Institute of Arts, which the city said would be placed in a separate trust.

The official count, filed late Monday night, showed 82% of those eligible for a police or fire pension who voted supported the plan. Roughly 73% of other retirees and employees with pension benefits who voted favored the plan. Voting lasted through early July.

The voting margins from pension holders were seen as an endorsement for the city's plan to confront an estimated $18 billion in long-term obligations.

"The voting shows strong support for the City's plan to adjust its debts and for the investment necessary to provide essential services and put Detroit on secure financial footing," Detroit Emergency Manager Kevyn Orr said

Despite the critical nature of the vote, a sizable chunk of those eligible sat out. About 59% of police and firefighter pension holders and 42% of other pension holders cast ballots, according to the city's legal filing.

Some 32,000 current and retired city employees faced a stark choice: Vote for the plan to cut most pensions and eliminate a future cost-of-living increase, or reject the plan and risk more severe cuts.

"It is not what my heart wanted to do and it still isn't. But I have to support what's best for our retirees," Shirley Lightsey, president of Detroit Retired City Employees Association, said in an interview Monday before the vote filing in bankruptcy court.

The vote, after weeks of tense campaigning, also sets up a confirmation trial scheduled for next month on the city's restructuring plan, the final phase of the bankruptcy case.

Federal bankruptcy Judge Steven Rhodes will have the final say, and will hold a trial on whether the city's reorganization plan, which also includes about $1.5 billion in reinvestment in services and blight removal, is viable.

On Monday, a court-appointed, independent financial expert came to that conclusion in a report. It found the city would likely be able to provide basic municipal services, meet revised obligations to creditors and avoid future default under the plan's terms and using its assumptions.

But Detroit's efforts to fix its ailing municipal services have also met resistance. A crackdown on delinquent water customers since March bubbled over with a public protest last week following concerns voiced by Judge Rhodes. On Monday, the city announced it would stop shutoffs for 15 days while it tries to promote its payment options and financial assistance available for customers.

Opposition has been building in Detroit for months after officials at the city's Water and Sewerage Department in March said they would shut off water service to delinquent customers.

Mr. Orr has said the water-shutoff approach—which affected more than 15,000 people, at least temporarily—wasn't misguided. Rather it was a sign of the city's effort to provide basic city services in a fiscally responsible fashion.

Things change, of course—the only constant in the Middle East is sudden and dramatic change—but as I write it seems as if Israel is losing the war in Gaza, even as it wins the battle against Hamas’s rocket arsenal, and even as it destroys the tunnels meant to convey terrorists underground to Israel (and to carry Israeli hostages back to Gaza).

This is not the first time Israel has found itself losing on the battlefield of perception. Why is it happening again? Here are five possible reasons:

1. In a fight between a state actor and a non-state actor, the non-state actor can win merely by surviving. The party with tanks and planes is expected to win; the non-state group merely has to stay alive in order to declare victory. In a completely decontextualized, emotion-driven environment, Hamas can portray itself as the besieged upstart, even when it is the party that rejects ceasefires, and in particular because it is skilled at preventing journalists from documenting the activities of its armed wing. (I am differentiating here between Hamas's leadership and Gaza's civilians, who are genuinely besieged, from all directions.)

2. Hamas’s strategy is to bait Israel into killing Palestinian civilians, and Israel usually takes the bait. This time, because of the cautious nature of its prime minister, Israel waited longer than usual before succumbing to the temptation of bait-taking, but it took it all the same. (As I’ve written, the seemingly miraculous Iron Dome anti-rocket system could have provided Israel with the space to be more patient than it was.) Hamas’s principal goal is killing Jews, and it is very good at this (for those who have forgotten about Hamas's achievements in this area, here is a reminder, and also here and here), but it knows that it advances its own (perverse) narrative even more when it induces Israel to kill Palestinian civilians. This tactic would not work if the world understood this, and rejected it. But in the main, it doesn’t. Why people don’t see the cynicism at the heart of terrorist groups like Hamas is a bit of a mystery. Here is The Washington Post on the subject:

The depravity of Hamas’s strategy seems lost on much of the outside world, which — following the terrorists’ script — blames Israel for the civilian casualties it inflicts while attempting to destroy the tunnels. While children die in strikes against the military infrastructure that Hamas’s leaders deliberately placed in and among homes, those leaders remain safe in their own tunnels. There they continue to reject cease-fire proposals, instead outlining a long list of unacceptable demands.

2. People talk a lot about the Jewish lobby. But the worldwide Muslim lobby is bigger, comprising, among other components, 54 Muslim-majority states in the United Nations. Many Muslims naturally sympathize with the Palestinian cause. They make their voices heard, and they help shape a global anti-Israel narrative, in particular by focusing relentlessly on Gaza to the exclusion of conflicts in which Muslims are being killed in even greater numbers, but by Muslims (I wrote about this phenomenon here).

3. If you've spent any time these past few weeks on Twitter, or in Paris, you know that anti-Semitism is another source of Israel’s international isolation. One of the notable features of this war, brought to light by the ubiquity and accessibility of social media, is the open, unabashed expression of vitriolic Jew-hatred. Anti-Semitism has been with us for more than 2,000 years; it is an ineradicable and shape-shifting virus. The reaction to the Gaza war—from the Turkish prime minister, who compared Israel's behavior unfavorably to that of Hitler's, to the Lebanese journalist who demanded the nuclear eradication of Israel, to, of course, the anti-Jewish riots in France—is a reminder that much of the world is not opposed to Israel because of its settlement policy, but because it is a Jewish country.

4. Israel’s political leadership has done little in recent years to make their cause seem appealing. It is impossible to convince a Judeophobe that Israel can do anything good or useful, short of collective suicide. But there are millions of people of good will across the world who look at the decision-making of Israel’s government and ask themselves if this is a country doing all it can do to bring about peace and tranquility in its region. Hamas is a theocratic fascist cult committed to the obliteration of Israel. But it doesn’t represent all Palestinians. Polls suggest that it may very well not represent all of the Palestinians in Gaza. There is a spectrum of Palestinian opinion, just as there is a spectrum of Jewish opinion.

I don’t know if the majority of Palestinians would ultimately agree to a two-state solution. But I do know that Israel, while combating the extremists, could do a great deal more to buttress the moderates. This would mean, in practical terms, working as hard as possible to build wealth and hope on the West Bank. A moderate-minded Palestinian who watches Israel expand its settlements on lands that most of the world believes should fall within the borders of a future Palestinian state might legitimately come to doubt Israel’s intentions. Reversing the settlement project, and moving the West Bank toward eventual independence, would not only give Palestinians hope, but it would convince Israel’s sometimes-ambivalent friends that it truly seeks peace, and that it treats extremists differently than it treats moderates. And yes, I know that in the chaos of the Middle East, which is currently a vast swamp of extremism, the thought of a West Bank susceptible to the predations of Islamist extremists is a frightening one. But independence—in particular security independence—can be negotiated in stages. The Palestinians must go free, because there is no other way. A few months ago, President Obama told me how he views Israel's future absent some sort of arrangement with moderate Palestinians:

[M]y assessment, which is shared by a number of Israeli observers ... is there comes a point where you can’t manage this anymore, and then you start having to make very difficult choices. Do you resign yourself to what amounts to a permanent occupation of the West Bank? Is that the character of Israel as a state for a long period of time? Do you perpetuate, over the course of a decade or two decades, more and more restrictive policies in terms of Palestinian movement? Do you place restrictions on Arab-Israelis in ways that run counter to Israel’s traditions?

Obama raised a series of prescient questions. Of course, the Israeli government's primary job at the moment is to keep its citizens from being killed or kidnapped by Hamas. But it should work to find an enduring solution to the problem posed by Muslim extremism. Part of that fix is military, but another part isn't.

5. Speaking of the Obama administration, the cause of a two-state solution would be helped, and Israel's standing would be raised, if the secretary of state, John Kerry, realized that such a solution will be impossible to achieve so long as an aggressive and armed Hamas remains in place in Gaza. Kerry's recent efforts to negotiate a ceasefire have come to nothing in part because his proposals treat Hamas as a legitimate organization with legitimate security needs, as opposed to a group listed by Kerry's State Department as a terror organization devoted to the physical elimination of one of America's closest allies. Here is David Horovitz's understanding of Kerry's proposals:

It seemed inconceivable that the secretary’s initiative would specify the need to address Hamas’s demands for a lifting of the siege of Gaza, as though Hamas were a legitimate injured party acting in the interests of the people of Gaza — rather than the terror group that violently seized control of the Strip in 2007, diverted Gaza’s resources to its war effort against Israel, and could be relied upon to exploit any lifting of the “siege” in order to import yet more devastating weaponry with which to kill Israelis.

I'm not sure why Kerry's proposals for a ceasefire seem to indulge the organization that initiated this current war. Perhaps because Kerry may be listening more to Qatar, which is Hamas's primary funder, than he is listening to the Jordanians, Emiratis, Saudis, and Egyptians, all of whom oppose Hamas to an equivalent or greater degree than does their ostensible Israeli adversary. In any case, more on this later, as more details emerge about Kerry's efforts. For purposes of this discussion, I'll just say that Israel won't have a chance of winning the current struggle against Hamas's tunnel-diggers and rocket squads if its principal ally doesn't appear to fully and publicly understand Hamas's nihilistic war aims, even as it works to shape more constructive Israeli policies in other, related areas.

An old foreign correspondent friend of mine, once based in Jerusalem, has turned to blogging. As the story he used to cover flared up once more, he wrote: “This conflict is the political equivalent of LSD – distorting the senses of all those who come into contact with it, and sending them crazy.” He was speaking chiefly of those who debate the issue from afar: the passions that are stirred, the bitterness and loathing that spew forth, especially online, of a kind rarely glimpsed when faraway wars are discussed. While an acid trip usually comes in lurid colours, here it induces a tendency to monochrome: one side is pure good, the other pure evil – with not a shade of grey in sight.

But the LSD effect also seems to afflict the participants in the conflict. They too can act crazy, taking steps that harm not only their enemy but themselves. Again and again, their actions are self-defeating.

Start with Israel – and not with the politicians and generals, but ordinary Israelis. Right now they are filled with the burning sense that the world does not understand them, and even hates them. They know Israel is being projected on the world’s TV screens and front pages as a callous, brutal monster, pounding the Gaza strip with artillery fire that hits schools, hospitals and civilian homes. They know what it looks like – but they desperately want the world to see what they see.

In their eyes, they are only doing what any country – or person, for that matter – would do in the same position. They ask what exactly would Britain do if enemy rockets were landing on our towns and villages. Would we shrug our shoulders, keep calm and carry on – or would we hit back?

But it’s not the rockets that frighten them most. Israelis focus more on the hidden tunnels dug under the Gaza border, apparently designed to allow Hamas militants to emerge above ground and mount raids on Israeli border villages and kibbutzim, killing or snatching as many civilians as they can. Israel’s Iron Dome technology can zap incoming rockets from the sky, but what protection is there against a man emerging from a tunnel in the dark determined to kill you? The fact that tranquillisers and handcuffs were reportedly found in those tunnels, ready to subdue Israeli captives, only leaves Israelis more terrified.

This is why they wanted their government to hit back hard: remember, it was the discovery of the tunnels that prompted the ground offensive. Some Israelis see the terrible images of Palestinian suffering – children losing their limbs, their lives or their parents – and they want the world to see it as they do: that Hamas shares in the blame for those cruel deaths, because it does so little to protect its civilians.

You might discount the argument that Hamas fights its war from civilian areas (replying that it’s hardly going to locate itself in open ground, wearing a target on its back). But the UN itself has condemned Hamas for stashing rockets in a UN school. And in the quiet years, when Hamas finally got hold of long-demanded concrete, it used it not to build bomb shelters for ordinary Gazans, but those tunnels to attack Israel, and bunkers for the organisation’s top brass.

I know that every one of those points can be challenged. The point is not that they represent unarguable truth but that they come close to how many – not all – Israelis feel. They believe they face in Hamas an enemy that is both explicitly committed – by charter – to Israel’s eradication, and cavalier about the safety of the Palestinian people it rules. They fear Hamas, its tunnels and its rockets, and they want security.

But here is where the madness kicks in. Israelis want security, yet their government’s actions will give it no security. On the contrary, they are utterly self-defeating.

That’s true on the baldest possible measure. More Israelis have died in the operation to tackle the Hamas threat than have died from the Hamas threat, at least over the past five years. Put another way, to address the risk that hypothetical Israeli soldiers might be kidnapped, 33 actual Israeli soldiers have died. Never before have international airlines suspended flights into Israel’s national airport. But they did this week, a move that struck a neuralgic spot in the Israeli psyche: if disaster struck, there’d be no escape. (That’s long been true of Gaza, of course.)

Before the current round of violence, the West Bank had been relatively quiet for years. Friday saw a “day of rage,” with several Palestinians killed and talk of a third intifada. An operation designed to make Israel more secure has made it much less.

If that is true now – with the prospect of an uprising encompassing not just the West Bank but some of the 1.7 million Palestinian citizens of Israel as well – it’s truer still in the future. For every one of those Gazan children – their lives broken by pain and bloodshed three times in the past six years – will surely grow up with a heart hardened against Israel, some of them bent on revenge. In trying to crush today’s enemy, Israel has reared the enemy of tomorrow.

Security requires more than walls and tanks. It requires alliances and support. Yet every day Israel is seen to be battering Gaza, its reservoir of world sympathy drops a little lower. And that is to reckon without the impact of this violence on Israel’s own moral fibre. After 47 years of occupation and even more years of conflict, the constant demonisation of the enemy is having a corrosive effect: witness the “Sderot cinema”, the Israelis gathering in lawn chairs on a border hilltop to munch popcorn and watch missiles rain down on Gaza. No nation can regard itself as secure when its ethical moorings come loose.

The only real security is political, not military. It comes through negotiation, not artillery fire. In the years of quiet this should have been the Israeli goal. Instead, every opening was obstructed, every opportunity spurned.

And the tendency to self-harm is not confined to Israel. Hamas may have reasserted itself by this conflict, renewing its image as the champion of Palestinian resistance. But it’s come at a terrible price. After an escalation that was as much Hamas’s choice as Israel’s, 800 Palestinians are now dead, 5,400 are injured and tens of thousands have been displaced. For those Palestinians yearning for a state that will include the West Bank, that goal has been rendered even more remote: what, Israelis ask, if the West Bank becomes another Gaza, within even closer firing range of Ben Gurion airport?

This is the perverse landscape in which both Israelis and Palestinians find themselves. They are led by men who hear their fear and fury – and whose every action digs both peoples deeper into despair.

As a Jewish youngster growing up in Budapest, an infant survivor of the Nazi genocide, I was for years haunted by a question resounding in my brain with such force that sometimes my head would spin: “How was it possible? How could the world have let such horrors happen?”

It was a naïve question, that of a child. I know better now: such is reality. Whether in Vietnam or Rwanda or Syria, humanity stands by either complicitly or unconsciously or helplessly, as it always does. In Gaza today we find ways of justifying the bombing of hospitals, the annihilation of families at dinner, the killing of pre-adolescents playing soccer on a beach.

In Israel-Palestine the powerful party has succeeded in painting itself as the victim, while the ones being killed and maimed become the perpetrators. “They don’t care about life,” Israeli Prime Minister Benjamin Netanyahu says, abetted by the Obamas and Harpers of this world, “we do.” Netanyahu, you who with surgical precision slaughter innocents, the young and the old, you who have cruelly blockaded Gaza for years, starving it of necessities, you who deprive Palestinians of more and more of their land, their water, their crops, their trees — you care about life?

There is no understanding Gaza out of context — Hamas rockets or unjustifiable terrorist attacks on civilians — and that context is the longest ongoing ethnic cleansing operation in the recent and present centuries, the ongoing attempt to destroy Palestinian nationhood.

The Palestinians use tunnels? So did my heroes, the poorly armed fighters of the Warsaw Ghetto. Unlike Israel, Palestinians lack Apache helicopters, guided drones, jet fighters with bombs, laser-guided artillery. Out of impotent defiance, they fire inept rockets, causing terror for innocent Israelis but rarely physical harm. With such a gross imbalance of power, there is no equivalence of culpability.

Israel wants peace? Perhaps, but as the veteran Israeli journalist Gideon Levy has pointed out, it does not want a just peace. Occupation and creeping annexation, an inhumane blockade, the destruction of olive groves, the arbitrary imprisonment of thousands, torture, daily humiliation of civilians, house demolitions: these are not policies compatible with any desire for a just peace. In Tel Aviv Gideon Levy now moves around with a bodyguard, the price of speaking the truth.

I have visited Gaza and the West Bank. I saw multi-generational Palestinian families weeping in hospitals around the bedsides of their wounded, at the graves of their dead. These are not people who do not care about life. They are like us — Canadians, Jews, like anyone: they celebrate life, family, work, education, food, peace, joy. And they are capable of hatred, they can harbour vengeance in the hearts, just like we can.

One could debate details, historical and current, back and forth. Since my days as a young Zionist and, later, as a member of Jews for a Just Peace, I have often done so. I used to believe that if people knew the facts, they would open to the truth. That, too, was naïve. This issue is far too charged with emotion. As the spiritual teacher Eckhart Tolle has pointed out, the accumulated mutual pain in the Middle East is so acute, “a significant part of the population finds itself forced to act it out in an endless cycle of perpetration and retribution.”

“People’s leaders have been misleaders, so they that are led have been confused,” in the words of the prophet Jeremiah. The voices of justice and sanity are not heeded. Netanyahu has his reasons. Harper and Obama have theirs.

And what shall we do, we ordinary people? I pray we can listen to our hearts. My heart tells me that “never again” is not a tribal slogan, that the murder of my grandparents in Auschwitz does not justify the ongoing dispossession of Palestinians, that justice, truth, peace are not tribal prerogatives. That Israel’s “right to defend itself,” unarguable in principle, does not validate mass killing.

A few days ago I met with one of my dearest friends, a comrade from Zionist days and now professor emeritus at an Israeli university. We spoke of everything but the daily savagery depicted on our TV screens. We both feared the rancour that would arise.

But, I want to say to my friend, can we not be sad together at what that beautiful old dream of Jewish redemption has come to? Can we not grieve the death of innocents? I am sad these days. Can we not at least mourn together?

Leo de Bever, CEO of the C$70 billion (US$65.2 billion) Alberta Investment Management Corp., Edmonton, told participants at a financial analysts conference Thursday that pension funds and other institutional investors need to get out of their comfort zones to take advantage of “the next frontier” of long-term investing — finding return “between the cracks” of asset silos.

Speaking at the CFA Institute conference in Chicago, Mr. de Bever talked about AIMCO’s “big themes” in long-term investments — energy, food, materials and robotic technologies — saying those industries are in a similar position to where infrastructure, timberland and commodities were to pension funds in the 1990s.

“What was new in the 1990s is conventional today,” Mr. de Bever said. “Extraordinary results are not possible using ordinary means.”

He pointed to the C$17.5 billion Alberta Heritage Savings Trust Fund, a sovereign wealth fund from provincial oil and gas revenue managed by AIMCO, that’s investing C$500 million in Alberta-based technology with a 10- to 15-year time horizon.

“There’s no nice, neat recipe” for finding such investments, Mr. de Bever said. “These things often come out of thin air, where people are looking to solve problems before they happen. For example, it’s less expensive to find a solution for potential gas line leaks than it is to clean up a gas leak.”

He pointed to the difficulty in getting pension trustees on board with such investments. “Is it easy to find these? No. Internal resistance is pretty strong. People have a tendency to work in silos.” But, he added, “if a strategy makes your board comfortable, it needs updating.”

AIMCO has 20% to 25% of its assets in what Mr. de Bever called “non-traditional asset classes,” which he said provides 30% of the overall portfolio’s risk. “But if these innovative themes pan out, a small investment now could earn AIMCO more in 10 years than we’ve returned overall in six years.

“Unusual investments can never be the dominant part of your portfolio,” he said. “They have higher risks, but it’s a smart way to make risk because the expected return should be much higher than other investments. If it’s not, you shouldn’t be doing it.”

Mr. de Bever called on pension fund investors to avoid the mainstream economic expectations that point toward trouble ahead. “The idea of a mediocre future is unwarranted,” he said. “If you don’t like that future, imagine a better one and try to make it happen.”

Among more traditional investments, Mr. de Bever said the future risk/return of stocks will be better than bonds over the next 10 years, and he warned against loading up on fixed income. His clients “are coming around to the notion that maybe we’re right on this,” he said. “Here on in (for bonds), I think it’s going to be worse ... There are two ways to go, terrible or really terrible.”

That also won’t bode well for plans looking to employ liability-driven investment strategies, Mr. de Bever added. “Derisking strategies like LDI are OK with high rates. It’s much harder to do now,” he said. “LDI has probably seen better days.”

Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.

Those having second thoughts include officials at the largest public pension fund in the U.S., the California Public Employees' Retirement System, or Calpers. Its hedge-fund investment is expected to drop this year by 40%, to $3 billion, amid a review of that part of the portfolio, said a person familiar with the changes. A spokesman declined to comment on the size of the reduction but said the fund is taking more of a "back-to-basics approach" with its holdings.

The retreat comes after many pension funds poured money into hedge funds in recent years in hopes of making up huge shortfalls.

The officials overseeing pensions for Los Angeles's fire and police employees decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to Los Angeles Fire and Police Pensions General Manager Ray Ciranna. The hedge-fund investment was just 4% of the pension's total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.

"We were ready to move on," Mr. Ciranna said.

Before 2004, public pensions favored plain-vanilla investments and avoided hedge funds almost entirely, according to data compiled by consultant Wilshire Trust Universe Comparison Service. Public pensions began wading into hedge funds roughly a decade ago as they sought to boost long-term returns and close the gap between assets and future obligations to retirees.

Hedge funds typically bet on and against stocks, bonds or other securities, often using borrowed money. Hedge funds also charge higher fees, usually 2% of assets under management and 20% of profits.

Many hedge funds dropped less than the overall market during the financial crisis, and some even posted outsize gains by anticipating the collapse. That performance accelerated the flow of pension money into hedge funds.

The move was part of a wider embrace of alternative investments, including private equity and real estate, as pension officials looked to diversify holdings in case more conventional investments faltered. They also hoped bigger investment gains would help them avoid extracting larger contributions from employees or reducing benefits for current or future retirees.

With many hedge funds, that sort of outperformance hasn't materialized in recent years: Average public-pension gains from hedge funds were 3.6% for the three years ended March 31 as compared with a 10.9% return from private-equity investments, a 10.6% return from stocks and 5.7% from fixed-income investments, according to a Wilshire review of public pensions with more than $1 billion in assets.

After peaking at 1.81% in 2011, pension allocations to hedge funds dipped to 1.21% of total portfolios as of March 31, according to Wilshire's review.

The average amount committed to private equity, by comparison, still is climbing. Those investments jumped to a decadelong high of 10.5% as of March 31, according to Wilshire. Stocks and bonds are still the dominant investments for all public pensions.

The reconsideration of hedge funds as an investment option hasn't produced significant shifts inside all funds. Some big public pensions said they are holding firm on commitments or increasing allocations as they worry about how stocks will perform in any future downturn. About half of the U.S. public pensions still have some sort of hedge-fund investment, according to data tracker Preqin.

"We are seeing a little moving away from hedge funds," but so far it's "just on the margin," said Verne Sedlacek, the chief executive of Commonfund, a nonprofit that manages money for pension funds, endowments and other nonprofit groups.

How far Calpers goes with its hedge-fund review may influence decisions at other public pensions because of its size in the industry. The current value of its assets is roughly $301 billion. The examination began in March as officials inside the fund began raising questions about whether hedge funds are too complicated or can effectively balance out poor-performing stocks during a market crash, said a person familiar with the situation.

A Calpers spokesman said the investment staff will make a formal recommendation to the board in the fall. But some cuts already have been made, said the person familiar with the situation. Hedge funds represented 1.5% of Calpers's total assets, or $4.5 billion, as of June 30.

Other states have made reductions as well. The School Employees Retirement System of Ohio decided to lower its hedge-fund allocation to 10% by fiscal 2015 as compared with roughly 15% in fiscal 2013 after investment gains were lower than expected, according to a spokesman. New Jersey's State Investment Council lowered its planned allocation to hedge funds to 12% from 12.25% as part of its fiscal 2014 plan, according to a spokesman.

The debate in San Francisco is indicative of those under way nationwide.

Board members of the San Francisco Employees' Retirement System are considering whether to invest 15% of assets into hedge funds for the first time. A debate about that strategy dominated a June meeting, in which board member Herb Meiberger argued hedge funds have blown up in the past and aren't the only investment alternative. The fund's executive director couldn't be reached for comment Wednesday.

Mr. Meiberger said at the meeting that he had sought out Warren Buffett's advice on the matter. The billionaire investor's handwritten response: "I would not go with hedge funds—would prefer index funds."

The California Public Employees’ Retirement System’s (CalPERS) interim CIO lauded its performance for the recent fiscal year in public equities (24.8%), private equity (20%), and even fixed income (8.3%). All together, CalPERS’ assets returned 18.4% in 2013-14.

One asset class notably did not get a shout-out from Ted Eliopoulos in his discussion of the results: hedge funds, or—as CalPERS refers to the bucket—absolute return strategies.

The $4 billion allocation made up only a small portion of CalPERS’ $302 billion portfolio, but that slice may get even smaller.

Citing an unnamed source, the Wall Street Journal reported July 23 that the pension fund planned to cut hedge fund allocation by 40%, to $3 billion. Given CalPERS’ July 23 valuation of its hedge fund portfolio, a 40% cut would in fact leave a $2.4 billion bucket.

CalPERS spokesperson Joe DeAnda also disputed that a decision had been reached about its hedge fund program, but confirmed to CIO that changes may be afoot: “The program is under review and has been discussed by the board several times in open session. No decisions have been made about the program at this time. During the review, the ARS portfolio may change in size and structure but conclusion of the review, and formal decisions about the program, likely will not occur until end of Q3 2014 at the earliest.”

In the fiscal year ending June 30, CalPERS’ hedge fund portfolio returned 7.1%, according to preliminary results, which was the weakest of any asset class except cash.

Eliopoulos, who has led the US’ largest public pension fund during its CIO search  remarked that the last year had been “so far, so good.” He noted that CalPERS had posted double-digit returns for four out of the last five years, but cautioned that 2013-14 was “unusual” on two counts.

“One: This sheer magnitude”—25%—“of the public equity performance… That’s a big number. And that’s unusual,” he said.

Secondly, “What you’d expect in a year like that when our equity portfolio is doing so well is that the other asset classes—and in particular, fixed income—would have a less robust or even a negative return,” Eliopoulos explained. CalPERS’ fixed income program in fact beat its hedge fund investments and returned 8%.

“Having all of the major asset classes return positive numbers is somewhat unusual.”

During the past few months, we have posted a few words here on the quandary that is hedge funds. The first such effort was titled “The Hedge-Fund Manager Dilemma,” and it explored the public’s fascination with the hedge-fund crowd. The second, “Why Investors Love Hedge Funds,” looked at why, despite stunning underperformance during the past decade, so much money was still flowing to the hedge funds.

Now, we are seeing early signs that some institutional investors are losing patience. Case in point: California Public Employees' Retirement System. The Wall Street Journal noted that the pension fund is looking to reduce hedge-fund holdings by as much as 40 percent. “Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.” 

Although this might be a rational response to issues of costs and performance, I would hasten to add that this is only anecdotal evidence. When we look at data such as money flows, it suggests hedge funds are continuing to pull in cash at an astounding pace. The hedge-fund-industrial complex now commands more than $3 trillion in assets. That is up from $2.04 trillion in 2012, and a mere $118 billion in 1997.

Calpers has a reputation for being a thought leader in the institutional-investment world. I have spoken with various pension funds and foundations over the past few years, and while the issue of hedge funds is under discussion, there is no consensus. Based on what various folks in the U.S. and Europe say, there still is great interest in hedge funds. Many investors are more than willing to forsake beta (returns that match the market) in the mad pursuit of alpha (above-market returns).

Still, this looks like it might be the start of something interesting. Given hedge-fund performance relative to the costs, I assumed a shift would have happened years ago. That it hasn’t likely reflects some combination of institutional inertia at big institutional and pension funds and perhaps the impact of consultants.

The Wall Street Journal noted that before 2004, “public pensions favored plain-vanilla investments and avoided hedge funds almost entirely.” The attempt to “boost long-term returns” was driven by the funding gap between assets and future obligations.

This is the crux of the issue: Expected returns. For reasons that remain unexplained, anticipated returns for hedge funds are always far higher than those of bonds and equities. There is no evidence for this erroneous assumption. Unless you are one of the lucky few in a top-performing hedge fund -- that means a small fraction of that $3 trillion in assets -- there is simply no logical or statistical basis for this expectation. It is false, a demonstrably wrong perception, yet one that has become widely accepted.

If anyone has an explanation for how these unfounded expectations came about, or why they persist, please let me know. I am well aware that politicians have embraced these false numbers, as it reduces the amount of contributions they need to make each year to public-pension funds. But it also kicks the can down the road, creating an even bigger hole in future budgets. At this stage, I shouldn't be surprised at irrational policies from innumerate politicians -- but I am.

Regardless, this is a trend that bears watching. The top funds in each category of alternative investment -- venture capital, private equity and hedge funds -- likely have little to fear. The remaining 90 percent of the players in this space should pay close attention. Some changes might be coming.

Argentina faced a race against on time on Wednesday to avert its second default in 12 years, needing either to cut a deal by the end of the day with "holdout" investors suing it or to win more time from a U.S. court to reach a settlement.

Argentine Economy Minister Axel Kicillof hurried to New York on Tuesday to join last-ditch negotiations, holding the first face-to-face talks with the principals of New York hedge funds who demand full repayment on bonds they bought at a discounted rate after the country defaulted in 2002.

Kicillof emerged from talks late on Tuesday, saying only that they would resume on Wednesday, but mediator Daniel Pollack said issues dividing the parties "remain unresolved" and that the two sides had not decided whether to meet on Wednesday.

Argentina has until the end of Wednesday to break the deadlock. If it fails, U.S. District Judge Thomas Griesa will prevent Argentina from making a July 30 deadline for a coupon payment on exchanged bonds.

Argentina's key dollar bond due 2033 rose sharply on Wednesday, and its debt insurance costs fell as investors took some cheer from the meeting.

Argentina's five-year credit default swaps dropped 30 basis points from Tuesday's close to 1,869 basis points, according to Markit. The CDS had hit six-week highs on Tuesday. The nation's one-year credit default swaps dropped 51 basis points from Tuesday's close to 4,708 basis points.

The CDS continue to price in a very high probability of default in the near term.

"Bonds have fallen in recent days but are far from pricing a default," said Emiliano Surballe, fixed income analyst at Bank Julius Baer.

"While nothing has been done yet to avoid a default, the chances of a last-minute transfer of funds to pay creditors leaves the door open for a boom (if Argentina pays) or bust (should there be a default)," Surballe said.

The hedge funds are owed $1.33 billion plus accrued interest, but an equal treatment clause in an agreement Argentina made with bondholders in 2005 would cost the nation many billions more.

FOCUS ON RUFO CLAUSE

Latin America's No. 3 economy has for years fought the hedge funds that rejected large writedowns, but after exhausting legal avenues, it faces default if it cannot reach a last-minute deal. According to bank sources and media, a group of private banks in Argentina is set to offer to put up $250 million as a guarantee to convince lead holdouts of the nation's good faith and convince Griesa to re-establish the stay.

Kicillof's unexpected appearance in New York raised hopes that there was still time to avoid a default that would bring more pain to an economy already in recession, though not the economic collapse seen in 2002 when it defaulted on $100 billion in debt.

The Buenos Aires government has pushed hard for a stay of the U.S. court ruling that triggered Wednesday's deadline.

Its chances of success were boosted on Tuesday when holders of Argentina's euro-denominated exchanged bonds said a suspension would encourage a settlement.

They also said they would facilitate a deal by waiving the so-called RUFO clause that prevents Argentina from offering other investors better terms than it offered them.

Argentina has consistently argued the RUFO clause prohibits it from settling with the holdouts.

"Obtaining a waiver of the RUFO clause, however, will take time," the group of bondholders said in an emergency motion for a stay filed on Tuesday.

While unnerving, the debt crisis is a far cry from the turmoil of Argentina's record default in 2002 when dozens were killed in street protests and the authorities froze savers' accounts to halt a run on the banks.

Christine Lagarde, the head of the International Monetary Fund, said on Tuesday that an Argentine default was unlikely to prompt broader market repercussions, given the country's relative isolation from the international financial system.

Right from the start, the Argentine government's attitude to its debt dispute with US hedge funds has made it all but inevitable that the country will fail to reach a compromise.

"We're not going to default, they'll have to invent a new term to define what's happening," said President Cristina Fernandez de Kirchner last week, deep in denial, as the deadline loomed for the country to meet its obligation to the so-called "vulture funds".

Thanks to a US court decision, Argentina is required to pay $1.3bn (£766m) to investors who bought its bonds at a big discount after its economic meltdown and previous default in 2001-02.

It failed to do so by 30 June and a 30-day grace period is now set to expire.

But the government has been resisting this course of action, because it fears that this could lead to the unravelling of other debt deals that it struck with most of its creditors.

As a result, a second default is now in prospect, and the outcome could be painful for an economy that is already in recession.

Distressed debt

Last time around, Argentina was left unable to repay or service more than $100bn of debt. The resulting default meant that it has not been able to borrow further money on the international markets since then.

Two successive restructuring deals, in 2005 and 2010, covered the overwhelming majority of bondholders, who agreed to accept about one-third of what they were originally owed.

However, hedge funds NML and Aurelius Capital Management snapped up a large chunk of the remaining distressed debt at low prices and are now pressing to be paid the full face value of their holding.

Their case against the Argentine government has been trundling through the US judicial system for some time. But Buenos Aires didn't expect the crunch to come so soon.

President Fernandez's government fully expected the dispute to go all the way to the US Supreme Court, which would have bought the country more time.

But in June, the Supreme Court declined to hear Argentina's appeal against the decision of a lower court that made it liable for the money.

Under that court's ruling, Argentina cannot use the US financial system to keep paying the restructured bondholders unless it also pays the "vulture funds".

And there are other hold-outs from the previous restructuring deals who could now follow the hedge funds' example and press for the full face value of their bonds.

Wider economy

From Argentina's point of view, there is a legal obstacle to its acceptance of the hedge funds' terms: a clause in the deals with the restructured bondholders, known as Rufo (rights on future offers).

This clause, which expires at the end of the year, states that Buenos Aires cannot favour the hold-outs over those who accepted the restructuring deals.

Given the choice, Argentina would like to spin out the negotiations with the "vulture funds" until 2015, when the clause will no longer apply.

But the US courts have refused to comply, seeing the restriction as one of Argentina's own making that could be circumnavigated if the government wanted to.

And after all, why should the Argentine government put itself out? As Capital Economics emerging markets economist David Rees points out, any default will have a "negligible" direct impact on it.

"The authorities are already locked out of international markets and will remain so," he says.

"But default is likely to have negative consequences for the wider economy in two ways," he adds.

"First, it is likely to cause interest rates on corporate debt to increase, which may deter investment and hamper activity in the private sector.

"Second, default may spur some capital outflows, exacerbating a shortage of hard currency and putting renewed pressure on foreign exchange reserves and the peso."
Combative style

That hard currency shortage is reaching a critical point. The amount of foreign exchange held by the central bank fell by 30% last year and is now less than $30bn (£18bn) - the lowest level since 2006.

As well as allowing Argentina to service its debts, that money is also needed to finance imports. Capital outflows would also do further harm to an economy that is expected to contract by 1% this year.

Undeterred by all this, President Fernandez is ploughing on in her usual combative style, while seeking help from other quarters.

Earlier this month, she wangled an invitation to the Brics summit in the Brazilian city of Fortaleza as a special guest, alongside the leaders of member countries Brazil, Russia, India, China and South Africa.

While there, she obtained support from the group in her battle against the "vulture funds".

She also came away with assurances that the organisation's new Development Bank could well offer her an economic lifeline.

But Argentina's woes are testing her leadership style to the limit, while economic and political analysts are already hoping that the end of her mandate in October 2015 will usher in an era of renewal after the next presidential election.

Members of Argentina's banking association, known as Adeba, are working on a last-minute plan to help the country avoid default, according to people familiar with the matter.

News of the plan came as Argentina's economy minister said late Tuesday that the country would continue negotiations on Wednesday with holdout investors after failing to reach a deal during a full day of talks. Argentina needs to reach an agreement with the investors by Wednesday to prevent a default, which would be its second in 13 years.

Meanwhile, Argentina's representatives and the holdout creditors met face to face for the first time Tuesday, the court-appointed mediator, Daniel Pollack, said in a statement after the talks had concluded.

"The issues that divide the parties remain unresolved," Mr. Pollack said.

Mr. Pollack said Argentina and the holdouts hadn't yet determined whether and when to meet on Wednesday.

Elliott Management Corp., one of the leaders of the holdouts, couldn't immediately be reached for comment.

The bankers association's plan, which hasn't been completely hashed out among the banks, would entail buying the legal claim and paying off the holdout creditors who are suing Argentina in U.S. courts for full payment on bonds the country defaulted on in 2001.

In exchange, the banks would ask the holdouts to ask U.S. District Judge Thomas Griesa, whose ruling has barred Argentina from paying its restructured bondholders unless it pays off the holdouts, to suspend his ruling.

"There is a little bit of a mess within Adeba," said one of the people, noting that the president of one of the banks took the lead in trying to organize the plan without getting full authorization from the other banks.

Another person said the idea is for the banks to buy the government's claim in three cash installments. In exchange, the banks would ask the government to pay them back in bonds beginning in January, when a key clause in the case expires.

This clause, the "Rights Upon Future Offers," or RUFO clause, says that any voluntary deal offered to the holdouts before the end of this year must also be offered to the restructured bondholders. Argentina has argued that if it pays the holdouts, the country would also have to pay as much as $120 billion to other bondholders to comply with the RUFO clause.

"I don't think we can say today that this proposal from Adeba is firm," a person familiar with the situation said.

The person said the banks first need to agree among themselves on the details of the proposal, then they would need to get assurances from the government that they would be adequately compensated.

This plan, if it works, would be a huge breakthrough in a case that has weighed on the country's citizens and politicians, as well as lawyers and bondholders, for years.

Argentine officials were in talks with the mediator at his New York office for 12 hours on Tuesday.

Argentine Economy Minister Axel Kicillof arrived approximately seven hours into the negotiations.

Argentina missed an interest payment on its restructured bonds due June 30, and the grace period for that payment ends on Wednesday. A U.S. judge has said Argentina isn't allowed to make that payment until it pays the holdouts. Argentina had refused to pay the holdouts or even meet with them face-to-face for negotiations.

Argentina's dispute with these creditors is a long-standing battle that stems from the country's default in 2001. The holdouts were the approximate 7% of Argentina's bondholders who refused to accept the country's debt-restructuring offers in 2005 and 2010 and have instead sued for full payment.

A default could send Argentina's struggling economy deeper into recession and keep the country shut out of debt markets. Argentina already suffers from annual inflation that some economists estimate is close to 40%, and a default could fuel inflation further by putting pressure on the peso's value and making imports more expensive.

There have been moments in the decade-long legal battle between Argentina and a small group of hedge fund creditors known as NML Capital when one could only step back and think, The people running Argentina have got to be out of their minds.

One analyst note, however, suggests that Argentina may have been playing this thing the right way the whole time.

The Republic's leaders have until Wednesday to either pay NML more than $1.3 billion worth of debt; get a stay of payment to all bondholders holding this same debt (allowing the country more time to negotiate with NML); or face default.

For years the country has argued it should not have to pay NML 100 cents on the dollar for debt dating to its 2001 default, when over 90% of the same bondholders took a haircut.

The U.S. Supreme Court finally shut the door on that argument in June.

Despite several meetings with a special master of the court over the past few weeks, Argentina has been refusing to negotiate with NML until a stay of payment has been granted.

Now it's really down to the wire.

So Abadi & Co. Global Markets published a note outlining all the scenarios. It includes the table below (click on image to enlarge).

Now let's walk through the scenarios. Keep in mind that Argentina has said that it wants to pay this debt in 2015 because of something called the RUFO (Rights Upon Future Offers) clause. Basically the clause says if Argentina voluntarily negotiates better terms with some creditors before 2015, all creditors are entitled to those same improved terms.

Argentina has been saying that negotiating with NML triggers RUFO and opens it up to $15 billion worth of claims from other creditors holding the same bonds.

So with that ...

Both parties lose if Argentina goes into default. Argentina's domestic economy will suffer as will its relationship with the rest of the world. For NML, its claim will be undermined and the country will be even more justified in arguing that it can't pay.

NML wins if it gets paid in cash or bonds for obvious reasons, though it may not get absolutely full satisfaction of its claim if it gets paid in bonds.

Both parties win if Argentina is granted a stay and the Republic then stands by its word and negotiates with NML. NML gets paid in 2015, Argentina avoids default and doesn't have to deal with a bunch of RUFO claims.

But there's some stickiness there. First off, you have to trust that Argentina really means what it says and that it wants to negotiate to avoid triggering RUFO. Could be that Jan. 1, 2015, will come and go and Argentina will sill refuse to obey the court and pay NML.

Based on its previous behavior, such a move wouldn't be surprising. That's why the judge, Thomas Griesa, has already refused to place a stay on payment once this month.

The other thing you have to keep in mind is that Argentina has defaulted before and survived. Plus, in this case, the government isn't completely broke like it was in 2001. It could potentially keep the country running until 2015 when it could pay the holdouts without triggering RUFO.

So to Argentina this is the choice it's handing hedge fund managers — we, as a nation, will be paying you in 2015. We can do it in pain and under duress, or we can do it in compliance with the Court.

But it's 2015 or bust.

Now, this whole scenario is thrown for a loop if you don't buy that Argentina is waiting for RUFO to expire. Some people don't believe that argument. They think that since RUFO is only triggered if Argentina is voluntarily negotiating, being forced to negotiate by the court (i.e., what's happening now) does not trigger the clause anyway, so this is all a charade.

Graham Fisher analyst and debt specialist Josh Rosner is one of the people who have argued this. Not only does he think the country could avoid RUFO now if it wanted to, but he also thinks that if the country paid NML — thereby entering the international financial community having resolved its major debt disputes — it could easily raise the necessary money to pay RUFO claims even if the clause was triggered.

From Rosner's note:

"Argentina has ignored the reality that even if that $15 billion number was correct and the creditors unwilling to negotiate a payment formula that was acceptable to both parties, the government would still be able to manage the increased debt burden as a percent of GDP. Moreover, late last year, at least one Wall Street firm offered to raise the full $15 billion that the government claims it owes. If the government chose to raise capital as a means of resolving this impasse, it would normalize its relations with the international capital markets, reduce its cost of funds going forward and immediately begin to attract the foreign investment necessary to develop key industries, including its energy sector and the broader economy."

So maybe NML doesn't want the stay because it isn't buying this whole RUFO argument, the same way Rosner isn't, and isn't willing to give Argentina time to slip out of this one.

Or maybe NML just hasn't realized that Argentina is willing to sit in extreme discomfort until 2015.

The latter may sound crazy at first glance, but, when you think about it, it's kind of crazy like a fox.

"I could say, just to end a positive note, last week not only did Argentina almost win the World Cup, but the Chinese premier came to Argentina with 200 business executives, and he is setting up a $7.5 billion project lending facility plus a $11 billion currency swap facility. Chinese companies are looking seriously at investing in farms, farmland, grain production, and in the shale oil deposits that Argentina has, which are larger than the United States’, potentially.

So this country has great future, and I think it’s disappointing for the United States not to be able to behave in a more professional way toward Argentina, one that values this long-term relationship."

As The Nation has warned repeatedly, the unthinkable may now be rapidly unfolding in Ukraine: not just the new Cold War already under way but an actual war between US-led NATO and Russia. The epicenter is Ukraine’s eastern territory, known as the Donbass, a large industrial region heavily populated by Russian-speaking Ukrainian citizens and closely tied to its giant neighbor by decades of economic, political, cultural and family relations.

The shoot-down of Malaysian jetliner MH17 on July 17 should have compelled the US-backed government in Kiev to declare a prolonged cease-fire in its land and air attacks on nearby cities in order to honor the 298 victims, give international investigators safe access to the crash site, and begin peace talks. Instead, Kiev, with Washington’s backing, immediately intensified its attacks on those residential areas, vowing to “liberate” them from pro-Russian “terrorists,” as it brands resisters in eastern Ukraine, killing more innocent people. In response, Moscow is reportedly preparing to send heavy weapons to the “self-defenders” of the Donbass.

Now, according to a story in The New York Times of July 27, the White House may give Kiev sensitive intelligence information enabling it to pinpoint and destroy such Russian equipment, thereby, the Times article also suggests, risking “escalation with Russia.” To promote this major escalation, the Obama administration is alleging, without firm evidence, that Russia is already “firing artillery from its territory into Ukraine.” Virtually unreported, however, is repeated Ukrainian shelling of Russia’s own territory, which killed a resident on July 13.

In fact, Kiev has been Washington’s military proxy against Russia and its “compatriots” in eastern Ukraine for months. Since the political crisis began, Secretary of State John Kerry, CIA Director John Brennan and Vice President Joseph Biden (twice) have been in Kiev, followed by “senior US defense officials,” American military equipment and financial aid. Still more, a top US Defense Department official informed a Senate committee that the department’s “advisers” are now “embedded” in the Ukrainian defense ministry.

Indeed, Kiev cannot wage this war on its own citizens—a UN spokesperson says nearly 5,000 civilians have been killed or wounded, which may constitute war crimes—without the Obama administration’s political, economic and military support. Having also created hundreds of thousands of fleeing refugees, Ukraine is bankrupt, its industrial infrastructure damaged, and it is in political disarray, using ultranationalist militias and conscripting men up to 60 years of age.

All of this is unfolding in the context of Washington’s misleading narrative, amplified by the mainstream media, that the Ukrainian crisis has been caused entirely by Russian President Vladimir Putin’s “aggression.” In reality, his role has been mostly reactive.

In November 2013, the European Union, with White House support, triggered the crisis by rejecting Putin’s offer of an EU-Moscow-US financial plan and confronting Ukraine’s elected president, Viktor Yanukovych, with an unnecessary choice between “partnership” with Europe or with Russia. The proposal was laden with harsh financial conditions as well as “military and security” obligations. Not surprisingly, Yanukovych opted for a considerably more favorable financial offer from Putin. Imposing such a choice on the president of an already profoundly divided country was needlessly provocative.

By February, street protests against Yanukovych’s decision turned so violent that European foreign ministers brokered a compromise agreement tacitly supported by Putin. Yanukovych would form a coalition government; Kiev street militias would disarm; the next presidential election would be moved up to December; and Europe, Washington and Moscow would cooperate to save Ukraine from financial collapse. The agreement was overthrown by ultranationalist street violence within hours. Yanukovych fled, and a new government was formed. The White House quickly endorsed the coup.

If any professional “intelligence” existed in Washington, Putin’s reaction was foreseeable. Decades of NATO expansion to Russia’s border, and a failed 2008 US proposal to “fast-track” Ukraine into NATO, convinced him that the new US-backed Kiev government intended to seize all of Ukraine, including Russia’s historical province of Crimea, the site of its most important naval base. In March, Putin annexed Crimea.

Also predictably, the Kremlin’s reaction to developments in Kiev further aroused the rebellion in southeastern Ukraine already under way against the February coup. Within weeks, Ukraine was in a civil war that threatened to become international.

Since April, Putin and his foreign minister, Sergei Lavrov, have repeatedly called for a cease-fire and negotiations between Kiev and the rebels. Kiev, backed by the Obama administration, has refused to enact any cease-fire long enough to give negotiations a real chance, instead intensifying its war on its fellow citizens as “terrorists.” The White House, according to the Times article, is considering a further escalation, possibly with more dire consequences.

This, too, is a matter of “intelligence,” if any is being heeded in Washington. For historical, domestic and geopolitical reasons, Putin—or any other imaginable Kremlin leader—is unlikely to permit the Donbass to fall to Kiev, and thereby, as is firmly believed in Moscow, to Washington and NATO.If Putin does give the Donbass defenders heavy weapons, it may be because it is his only alternative to direct Russian military intervention, as Moscow’s diplomatic overtures have been rejected. The latter course could be limited to deploying Russian warplanes to protect eastern Ukraine from Kiev’s land and air forces, but perhaps not. Kremlin hawks, counterparts to Washington’s, are telling Putin to fight today in the Donbass or tomorrow in Crimea. Or as the head of the Carnegie Moscow Center summarizes their position, “It is no longer just a struggle for Ukraine, but a battle for Russia.”

If the hawks on both sides prevail, it might well mean full-scale war. Has there been any other occasion in the modern history of American democracy when such a dire possibility loomed without any public protest at high levels or debate in the establishment media? Nonetheless, the way out is obvious to every informed observer: an immediate cease-fire, which must begin in Kiev, enabling negotiations over Ukraine’s future, the general contours of which are well known to all participants in this fateful crisis.

Private-equity firms have all but stopped buying public companies, retreating from a cornerstone of their business as rising stock prices push acquisition targets out of reach.

Public companies taken private accounted for 3.5% of the $89 billion of U.S. leveraged buyouts in the first half of this year, the lowest share on record, according to data tracker S&P Capital IQ LCD. In the first half of 2008, at the apex of a buyout boom, these types of deals represented about 68% of all buyouts by dollar volume.

Instead, private-equity firms are buying companies from one another, a shift driven in part by the relative simplicity of completing an acquisition of a private company compared with a publicly traded one. Transactions between private-equity firms have made up 60% of U.S. leveraged buyout volume through June, according to S&P. That is a higher percentage than the ratio for any full year tracked by the firm, whose data date to 2002.

Overall dollar volume of U.S. leveraged buyouts through June was up 30% over the same period a year ago.

Carlyle Group LP this week said it would buy Acosta Inc., a marketing firm that helps consumer-goods companies launch products and track sales, from Thomas H. Lee Partners LP. Carlyle is paying roughly $4.8 billion, according to people familiar with the matter, making the deal one of the year's largest buyouts.

The Jacksonville, Fla., company has had four private-equity owners since 2004, including Carlyle, an increasingly common occurrence for businesses that generate enough cash to keep up with payments on the debt that private-equity firms use to buy and extract dividends from companies.

The trend marks a big change from earlier eras of private equity, when buyout firms plucked multibillion-dollar companies off the stock market with regularity. The bidding war leading up to KKR & Co.'s $25 billion buyout of RJR Nabisco Holdings Inc., in 1988, was detailed in a best-selling book, "Barbarians at the Gate," and a movie.

That deal opened the door to a burst of public-company takeovers in subsequent years and in the run-up to 2007's financial crisis.

The handful of public companies to go private this year are tiny in comparison. The largest deal has been Apollo Global Management LLC's $1.3 billion takeover of Chuck E. Cheese parent CEC Entertainment Inc. The other four, a maker of robotic cutting tools and a real-estate developer among them, cost private-equity buyers less than $400 million apiece.

"There have been some lessons learned," said David Mussafer, managing partner at Advent International, which is investing a $10.8 billion fund. "The badge of honor comes from the returns you generate for your fund, not the size of the deal."

Private-equity firms combine investors' cash and borrowed money to buy companies with the aim of selling them profitably a few years later. Public companies have historically been a top target, along with family-owned businesses and divisions carved out of corporations. Purchases of companies owned by buyout industry rivals aren't new, but they have become more frequent.

Higher stock prices are one reason, as they drive up public-company valuations. After a number of large deals backfired on private-equity firms amid the financial crisis, the companies since then have generally shied away from big buyouts.

The S&P 500 index soared 30% in 2013 and is up 6.6% this year.

Plus, with the rise of acquisition activity this year, corporate buyers who for long sat on the sidelines are now competing for deals.

Some say the private deals are proving good for business. On a call Wednesday discussing Carlyle's second-quarter results, co-Chief Executive David Rubenstein said returns on these deals "have been pretty robust for investors in recent years, and I think, therefore, you're likely to see more."

Private-equity executives also say deals with peers are simply easier. The stock market's run has prompted private-equity firms to seek ways to cash out of older investments in droves, making these firms motivated sellers, unlike many public companies that resist takeovers.

And public-company buyouts are more complex. They can require postagreement auctions, called "go-shop" periods, in which boards seek higher offers. Shareholders must approve deals. Lawsuits from shareholders challenge nearly every deal. Activist investors can enter the fray and agitate for higher prices.

"If you have a choice between a public company and a private company in the same industry, certainty of closing is much greater in a private deal," said Mel Cherney, co-chairman of the corporate department at law firm Kaye Scholer LLP.

Meanwhile, private-equity firms need to find companies to buy, if not public, then private. They have about $326 billion to put to work in buyouts, according to data provider Preqin.

Criticism of deals between firms has focused on what value one manager can bring after another has owned the company.

Mr. Rubenstein of Carlyle on Wednesday said that the deals "have had their ups and downs in terms of the way that people look at them" and the key is to "have a good management approach and a plan when you're buying."

A 2012 study by three European researchers compared the results of more than 5,300 leveraged buyouts from 1986 to 2007 and found that there often wasn't a big difference in performance between the 435 deals made between investment firms and buyouts of companies with other types of owners.

The researchers said the downside of these deals is limited, and so, too, is the upside.

William Conway Jr., co-founder and co-chief executive of the $199 billion alternative investment giant Carlyle Group , is in little doubt about where he wants to do deals.

“Europe is not just the safest place to be but the best place to be.”

Mr. Conway said the firm was in a bullish mood about making new investments and exiting existing holdings in the region.

“I expect interest rates to stay low for quite a while,” he said. “That allows us to pay one or two times [earnings before interest, taxes, depreciation and amortization] more and get the same return on deals.”

In the last 12 months, the Washington D.C.-based firm has been able to find “eight to 10 good deals and paid an average of 7.5 times [Ebitda] for those assets – much lower than multiples in the U.S.”, Mr. Conway added.

Carlyle yesterday reported strong figures for its 5.6 billion euro 2006-vintage Carlyle Europe Partners III fund, which has risen by 47% over the past year and generated performance fees of $44 million as a result of three exits in the second quarter of 2014.

The firm has a EUR3 billion target for its fourth European buyout fund and has secured EUR1.1 billion so far, according to a report in the Financial Times this week.

Private equity firms have made the most of buoyant market conditions in Europe this year to exit a host of investments, especially via the initial public offering route. Investment banks earned $2.9 billion from advising private equity clients on exits during the first half, according to the data provider Dealogic, up 54% year-on-year. The figure meant that exits accounted for the highest percentage of overall financial sponsor revenue over a half-year period on record.

Mr. Conway said Carlyle was making twice as many exits as acquisitions in the current market. “Companies we bought, we’re very happy we own,” he said. “[But] is it easier to buy or sell? It’s easier to sell.”

Last week, Carlyle announced the sale of Ada Cosmetics from its 2008-vintage Carlyle Europe Technology Partners II fund, with the German business netting the firm a three-times return. Caryle is also looking to raise EUR500 million for a new technology fund in Europe.

Other investments in the region include U.K. roadside assistance provider RAC, which Carlyle bought for 1 billion U.K. pounds in 2011, and U.K. taxi operator Addison Lee, which it acquired in a deal valued at about GBP300 million last April.

“Trying to find companies like RAC and Addison Lee is tough to do. And you’ve got to do something with them. It’s not a game of checkers,” said Mr. Conway.

He said that in Europe, the firm saw more value in deals in the “EUR150 million to EUR200 million equity check area” and that the healthcare sector was of particular interest. This is despite negative press in recent years around private equity’s involvement with healthcare companies, which has centred on deals including Blackstone 's ownership of Southern Cross and August Equity’s portfolio company Old Deanery Care Home.

“Some people don’t want to touch [the businesses] involving patients,” Mr. Conway added. “But the patients are a big part of [the sector].”

The Washington-based private equity firm appears to be benefiting from a buoyant stock market and strong prices for the companies and other assets they buy and sell across the globe.

Its economic net income, which is a popular method of measuring profitability at investment firms, more than doubled to $318 million compared to $156 million a year earlier. Revenue was $900 million.

“The big story is the strong performance of our European private equity businesses,” said co-chief executive William E. Conway, Jr. in a statement. He said the company’s Europe Partners III fund “has begun generating substantial realized performance fees, further diversifying the composition of Carlyle’s earnings. Our European technology funds are also performing exceptionally well.”

Carlyle earned $6.5 billion from the sale of companies in the second quarter, while at the same time it poured $3.4 billion of cash into new investments.

The company continues to raise money from investors at a prodigious rate, with $7.4 billion in new money entering its coffers in the quarter. Carlyle has raised $23.1 billion in the last 12 months.

The investment firm also announced a quarterly distribution to shareholders of 16 cents per share, which means the total distribution for the first two quarters is at 32 cents.

Carlyle Group, which bills itself as a global alternative asset manager, is one of the largest of its kind in the world, with $203 billion of assets under management across 126 funds and 139 fund of funds.
Its results follow strong earnings reports from rivals KKR & Co., and Blackstone Group.

Investors committed more money to Carlyle in the quarter, and the value of its assets appreciated, helping its assets under management exceed $200 billion for the first time. The firm reported $202.7 billion of assets under management as of June 30, compared with $198.9 billion at the end of March.

David M. Rubenstein, a co-chief executive, said that Carlyle was receiving a proportionately larger share of capital from wealthy individuals and from sovereign wealth funds. In the past, Mr. Rubenstein said, Carlyle got about 14 percent of its capital from sovereign wealth funds, but the proportion rose to about 25 percent in the recent quarter.

“The growth of the sovereign wealth funds is hard to overstate,” Mr. Rubenstein said, citing high oil prices and the growth of economies in Asia. “They just have so much money.”

The Volcker Rule may be causing Goldman Sachs to become greedy in the short-term as well.

The investment bank, which has long claimed to be focused on the long-term, beat Wall Street’s estimates in its second quarter. But those better-than-expected results came with a caveat. About $1.2 billion of the firm’s revenue, or nearly 15%, came from investment gains in the shares of private and public companies. That was $800 million more than a year before.

Goldman beat analyst estimates by $500 million. Without those equities gains, Goldman would not have beaten estimates. And Goldman will soon have to make do without those gains, much of which have come from its investments in private equity funds. PE funds, after all, are not Volcker-compliant.

Analysts and investors have known for a while that Goldman will eventually have to dump its private equity portfolio, which was valued at $8 billion at the end of the first quarter. On top of that, Goldman has another $2.4 billion in unfunded commitments, money it has pledged to private equity funds but has yet to contribute. It also has almost $5 billion in hedge funds and funds that invest in debt.

Under the Volcker Rule, big banks are not allowed to have more than 3% of their capital invested in private equity, hedge funds, and other investment funds. At Goldman, at the end of the third quarter, those investments equalled about 21%. So, the bank has a lot to sell.

It’s all a matter of timing. The Volcker Rule does not officially go into effect for another year. And Goldman can get an extension so it can hold on to some investments until 2017. So far, Goldman has been slowly selling its investments in hedge funds over the past three years, which are also not allowed under Volcker. But it’s mostly held onto its private equity portfolio. That may now be changing. When Goldman reports its official quarterly numbers to the SEC in the next week or so, a number of analysts expect to see a drop in its PE portfolio.

Goldman declined to comment for this article. In the past, the firm has given no firm timeline on the exit from its private equity positions. And the firm has said it will continue to manage private equity funds for outside investors. And it is reportedly looking for new ways to make private equity investments outside of specific funds. That might be a Volcker loophole. Still, the firm will have to exit much of its current private equity positions.

In theory, selling its PE investments shouldn’t affect its profits much. Goldman marks all of its investments to market, meaning that it takes any gains it has each quarter, not when it eventually sells. But if the bank ends up selling for more than it thinks its investments are worth, that difference would show up as a gain. That’s more likely to happen when Goldman exits the shares of private companies, because the value of those stakes are harder to estimate.

Goldman’s principal investment line on its balance sheet tends to be choppy, so it’s not unusual for it to jump around. And the second quarter’s earnings could have been a blimp. The $1.25 billion gain it registered from equity investments is the biggest it has had from that business in years.

The problem is those gains are coming at a time when earnings from Goldman’s traditional driver of profits—trading—has slumped, dragging down the firm’s overall profitability. Goldman’s return on equity in its most recent quarter was nearly 11%. Goldman’s ROE used to regularly top 20%. When the firm’s highly profitable private equity investment gains dry up, that ROE could drop even further.

But the bigger issue is determining what Goldman will do with the cash it gets after selling its positions. The lower ROE suggests that Goldman is having trouble finding places to put its cash that can generate higher returns. But that may not be a problem. Analyst Matthew Burnell of Wells Fargo says Goldman can give its cash back to shareholders if it can’t find high return investments for it. And the firm appears to be doing that. Burnell estimates that Goldman will pay out 85% of its earnings this year in dividends or buybacks to shareholders. That’s a much proportional pay out than what other large banks are doing, where payout ratios are averaging around 50%.

At the same time, handing money back to shareholders means that Goldman will have less capital to invest when Wall Street profitability does rebound. What’s more, all those payouts to shareholders doesn’t seem to be helping much. Shares of Goldman, which have been up recently, are basically flat for the year. Greed, no matter what Gordon Gecko says, doesn’t always work.

Premier Kathleen Wynne’s government is being ripped for keeping secret a report critical of bloated, taxpayer-funded pensions in the hydro sector since well before the June 12 election that lifted the Liberals to a majority.

The 45-page study into Ontario Power Generation, Hydro One, the Electrical Safety Authority and Independent Electricity System Operator recommends dramatically lower public contributions to “generous, expensive and inflexible” retirement schemes posing a “significant risk” to electricity prices.

At Hydro One, for example, taxpayers have been contributing an average of $5 for every $1 from employees, far higher than most civil service and private sector pension plans. Two-thirds of Ontarians have no workplace pension plan.

The report is dated March 18 and was posted on the Ministry of Finance website Friday on the eve of the Civic Holiday long weekend.

“This is awfully suspect,” said Progressive Conservative MPP Vic Fedeli, his party’s finance critic, questioning Wynne’s oft-stated goal of running an “open and transparent” government.

“There was ample opportunity to release this document with good public scrutiny. What are they hiding? What didn’t they want us to know?”

NDP pensions critic Jennifer French (Oshawa) said the Liberals “have been sitting in this report for five months.”

Government officials said they had intended to make the report public after Finance Minister Charles Sousa’s May 1 budget — which was rejected by opposition parties, forcing the election — and that posting it without fanfare was an oversight.

The Canadian Federation of Independent Business said the late release of the report is a blow to Wynne’s credibility as she pushes forward with an Ontario Registered Pension Plan (ORPP) for citizens without workplace pensions.

“Why now, why not before the election so people would have known what’s happening?” said Plamen Petkov, whose lobby group opposes the ORPP as too expensive.

“We’re very worried to see government agencies where employees are paying only 20 cents on the dollar for their pensions when taxpayers pay the other 80 cents. No wonder the government itself expects electricity prices to go up 42 per cent over the next five years,” he told the Star.

“It’s really disappointing. We recommend the government clean its own house first before they ask employers to contribute $3.5 billion a year to the Ontario Retirement Pension Plan.”

The report was written by Jim Leech, a former head of the Ontario Teachers’ Pension Plan appointed last December to find ways of making electricity sector pension plans more affordable as the government struggles to eliminate a $12.5 billion deficit by 2018.

“The pensions are generous,” he concluded, noting benefits are “very close” to the maximum allowable under the Income Tax Act, “richer than most of the broader public service plans and employee contributions are also lower.”

For example, the Ontario Power Authority’s pension plan has a 50/50 employer/employee contribution ratio — a level that Leech recommends be reached within five years.

His report provides “advice on a roadmap and potential destination that is both affordable and financially sustainable,” said Beckie Codd-Downey, spokeswoman for Energy Minister Bob Chiarelli.

“The government will be reviewing the report in consultation with union representatives to assess the recommendations.”

Pensions will be subject to collective bargaining between the electricity agencies and their employees.

Ontario taxpayers are putting in almost $5 for every $1 employees are putting into unsustainable pension plans at Ontario’s energy agencies, costs that pose a “significant risk” to electricity prices, according to a government-commissioned report released Friday.

Employees at the provincial transmission utility Hydro One provided a scant 12 per cent of contributions to their pension plan, compared to 81 per cent forked over by the Crown corporation, the report found.

Ontario Power Generation wasn’t much better, with employees putting in just 24 per cent of the contributions compared to 76 per cent by the publicly owned utility.

Compared to other public-sector pension plans, those at Ontario’s electricity agencies — including the Independent Electricity System Operator and Electrical Safety Authority — are “generous, expensive and inflexible,” special advisor Jim Leech said in his report dated March 18.

Employers are responsible for a larger share of the pension contributions compared to other plans and bear all risks that can increase pension costs, which are ultimately borne by ratepayers, customers and shareholders, he said.

The report also warned that none of the four pension plans, which collectively have about 18,000 active members and 19,000 retired and deferred members, is stable.

“The plans are far from sustainable,” Leech wrote. With employer contributions already high, none of the plans have the ability to absorb further market fluctuations, lower-than-estimated investment performance or costs associated with pensioners living longer.

“Should plans go further into deficit, the sponsors and, ultimately, ratepayers will be required to pay even larger contributions,” the report said.

In 2012, total contributions from all sources of the four plans were approximately $585 million, with $106 million from employees. The employer contributed $480 million, comprising about $365 million in current pension expense payments and $115 million in special payments required under law for deficits.

The report noted that all elements of the pension plans, including benefit levels and employee contribution rates, were negotiated through collective bargaining. The generous provisions include unreduced early retirement, maximum survivor benefits permitted by law and a “rich” benefit formula which uses the employee’s best three years plus bonuses in some cases, the report said.

Ancillary benefits account for a big chunk of the costs, it said, adding that the base pension represents less than 52 per cent of the total pension costs. And it’s taking its toll on the balance sheets of the government-owned corporations.

ESA, which is responsible for electrical safety, including the licensing of contractors and electricians, has absorbed a 115 per cent increase in annual pension costs into its operating budget over the last three years, the report said. In the last fiscal year, it ate up about 10 per cent of the not-for-profit corporation’s revenue.

The four energy companies also provide supplementary pension plans that provide additional benefits that are paid from the company’s general revenues, which have a cumulative unfunded liability of about $490 million.

Leech, former CEO of the Ontario Teachers’ Pension Plan, is recommending that the employer-employee contribution ratio for all four plans move to a target of 50/50 over the next five years.

The governing Liberals asked Leech to look into the energy sector pension plans following a damning report in December from the province’s auditor general.

Bonnie Lysyk found OPG contributed “disproportionately more” to its pension plan that its employees, with a funding ratio of 4:1 or 5:1, significantly higher than the 1:1 ratio in the public service. OPG is also solely responsible for financing its pension deficit, which stood at about $555 million.

The report was quietly posted on the Ministry of Finance’s website on Friday, a move the Progressive Conservatives called suspicious.

“They continue in the legislature to talk about being open and transparent, but when something like this comes along, it’s so blatantly obvious that they’ve gone out of their way,” said Tory finance critic Vic Fedeli.

“It was available before the election, it was available while the legislature was sitting and they did not release it then. They released it on the Friday of a long weekend in the middle of the summer more than four months later. That’s all very suspect, but very typical for this government.”

Skyrocketing hydro bills are the biggest concern for most of the people he spoke to during the pre-budget hearings, Fedeli said.

“When you see the cost of these pensions and you know that that transfers directly to hydro rates, it infuriates people in Ontario even more,” he added.

Beckie Codd-Downey, a spokeswoman for Energy Minister Bob Chiarelli, said the government will “review the report in consultation with union representatives to assess the recommendations.”

Benefits in these four plans are quite similar and they are very close to the maximum benefits allowed under the Income Tax Act.

In general, benefits in these plans are richer than most of the Broader Public Service (BPS) plans and employee contributions are also lower than BPS plans in general.

As noted earlier, features of certain plans include:

• maximum benefit accrual rates, at 2 per cent per year of service;
• retirement calculation based on best 3 years’ average salary,
• early unreduced retirement based on factor 82;
• CPP bridging benefit formula;
• fully guaranteed indexing; and
• maximum joint and survivor benefits.

Employee contributions for plan members are generally in the range of 6 to 7 per cent of salary; recently there have been some negotiated increases in employee contributions towards 7.75 per cent. This can be compared to Toronto Hydro and other local distribution companies in the municipal sector that are part of OMERS, which offers less generous benefits whereas employee contributions are currently over 14 per cent of salary.

As a result of generous benefits and larger employer contributions these plans are expensive. As noted earlier, employers bear the majority of costs. Based on the most recent valuation reports filed with the pension regulator, the Financial Services Commission of Ontario (FSCO), the employer current service cost represents approximately 18 per cent of payroll for OPG and 19 per cent of payroll for H1.

With special payments, employer contributions represent approximately 24 per cent and 27 per cent of payroll respectively. They are also close to 24 per cent for both IESO and ESA. (See Table 4 in Appendix B for further details).