Madoff’s Scheme Was Transparent yet Ignored. Get Ready for Round 2
The tragedy of Bernie Madoff’s Ponzi scheme that ruined so many lives, led to suicides and wiped out a mindboggling $60 billion was not the enormity of the fraud. It was that the scheme was so obvious that even the most superficial of reviews set off alarms. In 2000, 2001 and 2005 the SEC was warned by investors of the impossibility of Madoff’s returns, yet regulators never responded. If you’re a taxpaying citizen, this is maddening. All of the useless, never-ending regulations that spew from an overreaching bloated government – and no one followed up when handed a massive Ponzi scheme that was their job to discover in the first place? Worse still, the SEC never figured out Madoff’s scheme – he turned himself in when the obvious conclusion became society’s problem.
Today, we are witnessing a similar tale of gross negligence unfold in the investment world that is far larger in scale, potentially impacting all pensions throughout the country. On this go-round, however, the incompetence flows from lettered professionals who consult for retirement plans. Pension consultants oversee an estimated $10 trillion while drawing hundreds of millions in fees from pensioners. This despite recusing themselves from the same transparency of performance they demand of managers. In the opinion of numerous studies, such as those done by Oxford, pension consultants are “useless” – save for one purpose. In theory, the pension consultant gives legal protection to the boards of pensions, often made up of hard working individuals such as policemen, firefighters and carpenters. However, this theoretical legal protection begins to break down when it threatens the ability for many baby boomers to retire safely.
What is the prime negligence within the actions of these pension funds? The diversification of risk management, which is the fundamental cornerstone of investment consultation. While no pension consultant would be naive enough to argue this reality, in practice pension consultants do not routinely put this fiduciary duty in play.
Portfolio diversification does not come from owning a magic number of equities, public or private. As the number of equities in a portfolio moves beyond 25, the impact on a portfolio diminishes asymptotically. Moreover, the greater the number of equities in a portfolio, the greater the portfolio correlation is to market direction. This is particularly true during periods of falling markets when diversification is most critical. Even more alarming is the reality that bonds, an asset that pension consultants point to as diversification and the second biggest asset dominating American pensions, are uncomfortably correlated to equities and don’t come close to adequately diversifying portfolios.
Chaves et al. looked at other assets utilized by pension consultants and sounded the alarm bell: even the assets pensions place around their bloated equity and fixed income exposures are correlated. It was this same reality that led Michael Burry, who correctly saw the ’08 meltdown and was profiled in The Big Short, to say, “The incredible correlation … is problematic.” Pension consultants’ timing couldn’t be more perilous, as equity markets are at or near all-time highs with valuations that suggest the ensuing performance will be very poor at a time when aging pensioners can least afford such recklessness.
So what exactly should pension consultants be doing to protect their retirees? They should follow these three key points necessary to rebuild confidence by ensuring that their allocations:
1) Are uncorrelated to the massive allocations they hold to stocks and bonds
2) Are liquid and time-tested with proven records
3) Are not vulnerable to excess systematic leverage
Pension consultants will argue this is impossible. Yet the solution has been around since the dawn of time. Could it be that the answer is so simple it threatens the relevance of pension consultants?
The answer is physical gold. Gold has traded freely for 46 years, a statistically significant data set. Over that time, gold has returned 8 percent annually, a very respectable number compared to equities and bonds, even with those markets at all-time highs. Consider, too, that central banks have invested over $10 trillion in the stock and bond markets, artificially inflating the returns of equities and fixed incomes on a global scale, which artificially suppresses gold’s returns. This distortion, admitted by all central banks, makes gold’s strong performance more noteworthy. Gold’s returns are even more impressive when one considers how superior the risk profile of gold is compared to equities and bonds. What risk really entails is the potential permanent loss of capital. That risk applies to stocks and bonds, but not gold, which has never defaulted and never hit zero. Gold carries no liabilities. Keep in mind that in the great market sell-off of 1929 and each major market correction in our own lifetimes – 1987, 2000 and 2008, gold markedly outperformed stocks by an average of 30 percent and over 50 percent if one includes the 1929 crash.