Fiduciaries and hedge funds
The following letters are in response to Charles J. Gradante's July 22 Other Views commentary, "Fund of hedge funds imprudent for fiduciaries."
Having furnished the expert testimony upon which the court based its decision in Whitfield vs. Cohen, I feel qualified to correct gross inaccuracies contained in Charles J. Gradante's commentary. The case had nothing to do with hedge funds. Nor did it involve a fund of funds. In short, Mr. Gradante has the basic facts of the case all wrong. (The subject investments were supposed to be second mortgages on residential properties, but to my knowledge no assets were ever located.)
Whitfield did outline basic duties of a fiduciary in selecting and monitoring investment managers, and that is why it has been cited with some regularity over the years. The heart of the decision is that, in selecting a manager, fiduciaries have a duty to learn enough about the manager and the proposed approach to constitute a prudent choice under prevailing standards for selecting managers. The decision also articulates the requirement of fiduciaries to perform certain minimal actions in monitoring a manager once the investment is made.
That said, I believe Whitfield does indeed have important implications for the use of hedge funds by ERISA plans and other fiduciaries. But it has to do with hedge fund transparency or lack of it, without regard to the presence or absence of a fund-of-funds manager. Absent transparency with respect to positions, trades and leverage, it strikes me as very difficult for a fiduciary to demonstrate that she has discharged her duty to monitor plan investments: You can't monitor what you can't see.
Interposing a fund-of-funds manager between fiduciary and hedge fund does not, in my opinion, relieve the fiduciary of her duty to monitor investments. It simply transforms the plan fiduciary's duty to that of ensuring the fund-of-funds manager gets sufficiently detailed and timely information from each underlying hedge fund to be able to demonstrate that it is in fact monitoring the investments - properly monitoring the fund-of-funds manager, in other words. Absent this, merely relying on the appointment of a fund-of-funds manager is to put one's head in the sand.
Richard M. Ennis
Ennis Knupp + Associates
Conflicted and wrong
I am an attorney who specializes in advising fiduciaries of plans in the private and public sectors. At an earlier stage of my career, during the Carter and early Reagan years, I was ERISA administrator at the Department of Labor.
It is based upon my experience in this area of the law that I write to protest the opinion expressed in the commentary by Charles J. Gradante. He writes that it is imprudent for plans to invest in funds of funds that in turn invest in hedge funds.
Initially, it does not appear that Mr. Gradante is an attorney, yet, he renders a "legal" opinion. Moreover, it does appear Mr. Gradante is in direct competition with funds of funds, since he is described as a consultant for plans investing directly in hedge funds, so he is obviously conflicted. Finally, and most important from my perspective, is that he is wrong - identical fiduciary protections exist for plans choosing to invest in funds of funds as exist for those that prefer to invest directly in hedge funds. I represent plan clients that invest either way or both ways in hedge funds while acting in full compliance with legal requirements.
Why would P&I choose to publish such an uninformed, biased article?
Ian D. Lanoff
Groom Law Group
Funds of funds prudent
Charles J. Gradante's argument revolves around three unusual premises. First, that fiduciaries are capable of analyzing and monitoring hedge funds directly; second, that a consultant on direct investments provides better monitoring of hedge funds than a fund-of-funds provider; and third, that fiduciaries are incapable of getting information on investments when investing in a fund of funds. I would argue that these are unstable arguments at best.
The real issue is the degree to which a hedge fund is willing to disclose information to investors or their agents, and their ability to understand that information and make reasonable, informed decisions. If investors or their agents cannot get sufficient information to make a decision, they should be wary about placing money in that investment, as he suggests. However, I have trouble believing that Mr. Gradante can get better information to communicate to his clients than his competition of fund-of-funds firms such as Ivy Asset Management, Grosvenor Capital, K2 Advisors, Lighthouse Partners and others.
His suggestion that "indirect investment through funds of funds is an imprudent option for fiduciaries" is clearly biased by his business interests. My view is that both direct and fund-of-funds investments are prudent as long as the investor or his or her agent can make an informed decision. As to our interests, Freeman & Co. has done business with both individual hedge funds and fund-of-funds firms in providing merger-and-acquisition and strategic advice.
Eric C. Weber
director-asset management services
Freeman & Co.
No due diligence neglect
When Charles J. Gradante suggests fund sponsors might be breaching their fiduciary duty by investing in a fund-of-hedge-funds product, he is opposing a principle that has been applied successfully for decades in investments in other asset groups.
To suggest that hedge funds are somehow different in this regard is groundless.
Mr. Gradante argues that sponsors are abdicating their fiduciary duty because they cannot effectively monitor and influence the investment process by investing in a fund of funds. But an extension of Gradante's argument would mean fiduciaries should select and monitor each stock investment by an equity mutual fund rather than investing in the fund and delegating responsibility to the fund manager.
Indeed, delegation of a sponsor's investment management duties is even more appropriate in the case of the more esoteric hedge funds, which often require a more specialized understanding. After all, as Gradante himself says, the Employee Retirement Income Security Act and the Uniform Prudent Investor Act stipulate that sponsors are "obliged to delegate their investment management duties if they do not possess the requisite knowledge and expertise." What better way to delegate those duties and distribute the risk than to work with managers of a fund-of-funds product who have the required expertise and experience?
Even with the help of a consultant, analyzing each of today's 6,000 hedge funds to determine which fund is better, let alone monitoring them on a regular basis, would be a daunting task. Indeed, if hedge funds form only a relatively small proportion of a fund's overall investments, sponsors might find they are spending an inordinate 50% of their time on 5% of their investments - and the end result may be a lesser degree of due diligence.
Using a fund-of-funds approach instead of selecting and monitoring the investments themselves is a way to fulfill a fiduciary duty effectively and we believe it does not breach it. To argue the reverse appears misguided.
Frank Russell Co.
EBRI and WorldCom's 401(k)
On Aug. 5, Pensions & Investments ran an editorial under the title "EBRI miscalculation." Among other things, it characterized a media release from EBRI as "appalling." With due respect, I find your characterization inaccurate. Your editorial takes a point out of context, and then also treats it inaccurately.
The release responded to questions from the media and Congress about pension system implications. We noted that a total loss from the collapse of WorldCom Inc. would have a minor overall impact on the nation's pension system, noting public and private pension plans have just over $3.7 trillion in stocks and just over $1.5 trillion in bonds, at present market levels. Last fall as the nation reeled from terrorism, WorldCom stock had been worth $41.5 billion. Had it all been held by pension funds, it would have represented 1.1% of total assets, but pension funds hold about 23% of all equities in the U.S. market. Were the pension fund holdings in WorldCom proportional to the share of all stocks, then failure of WorldCom last year would have meant pension losses of about 0.26% of total assets.
When the market shut down on WorldCom trading recently, the total value of WorldCom stock was down to $2.4 billion. We pointed out that the bond picture was less severe. Public and private pension plans (again, both defined benefit and defined contribution plans, such as 401(k) plans) hold about 10.6% of all bonds in the economy. Had pension plans held all $38 billion in WorldCom bonds, it would have represented 2.5% of pension bond holdings.
As has been reported, some pension and annuity firms had what appeared to be large absolute dollars invested in WorldCom. However, when compared to total pension and annuity assets, the impact of even a WorldCom failure (were it to come) would be a small fraction of total assets and returns. The only point you chose to highlight was one line from a paragraph that read: "EBRI also noted that WorldCom - unlike Enron Corp.- did not require employees to invest their 401(k) company matching funds in WorldCom stock, and lists of corporate 401(k) plans with high levels of company stock compiled by IOMA (the Institute of Management and Administration) during their coverage of the Enron collapse did not include WorldCom as having heavy employee concentration in company stock. One recent published report indicated that about 0.3 percent of WorldCom's 401(k) plan assets were invested in WorldCom stock, indicating that few WorldCom 401(k) participants had their retirement plan assets affected by the collapse of their employer's stock value."*
The emphasized sentence was the subject with an interview with the Wall Street Journal, and our discussion with them led us to question the report of the Democratic Policy Committee and to obtain past WorldCom filings with the Department of Labor. Upon review, we issued a corrected release with the following revised words: "One recent published report indicated that about 0.3 percent of WorldCom's 401(k) plan assets were invested in WorldCom stock, a significant decrease from a figure exceeding 32 percent reported at the end of 2000 and 55 percent at the end of 1999.* Participants in the WorldCom 401(k) salary savings plan appear to have lost between $600 million and $1.8 billion as the stock price declined."
I have never refused to talk to a reporter, as it would be inconsistent with the EBRI mission, and in 24 years with EBRI I have never hesitated to correct or clarify numbers when we became aware of an error. That is because we are independent and impartial, and it is why we are credible. Your editorial, on the other hand, did not even accurately characterize the article from the Wall Street Journal to which you referred. As a reader, I expect a higher editorial standard of both completeness and fairness from your publication than this editorial represents.
Dallas L. Salisbury
president and chief executive officer
Employee Benefit Research Institute
*See Senate Democratic Policy Committee, "The Fortune 50: Company Stock as a Percentage of 401(k) Plan Assets," DPC Special Report, http: democrats.senate. gov/~dpc/pubs/107-2-60.html, which uses the 3%, but does not include the additional numbers provided here which are taken from form 5500 filed with the Labor Department by WorldCom Aug. 8, 2001.