The morphing of ETFs has caused some trepidation among regulators and market participants. In the U.S., a subcommitttee of the Senate Banking Committee held hearings in October last year to examine whether ETFs have departed so much from their traditional moorings as to become a snare for the unsuspecting.

Eileen Rominger, Director, Division of Investment Management at the U.S. Securities and Exchange Commission notes that ETFs account for $1 trillion in assets, or one-tenth of total mutual fund industry assets. They have a substantial market share and are growing. The problem is mostly how they are growing.

The worry is less with ETFs that hold the underlying shares of the indexes they track. It’s more with ETFs that mostly use over-the-counter swaps to replicate or synthesize exposure to the futures or commodities markets. As a result, the SEC has stopped giving exemptive relief to ETFs that rely heavily on derivative or swaps. As Rominger explains:

“For example, some [exchange-traded products], in the form of commodity-based trust-issued receipts, seek to track an index of futures on volatility of a portfolio of stocks, such as the S&P 500. Futures on volatility have added another dimension to the calculation to express future or expected volatility.  In addition, the Commission has witnessed an increase in the past few years in the variety of actively managed ETFs introduced by sponsors.  For example, while an assortment of actively managed ETFs based on fixed-income portfolios is listed and trading in the marketplace, there have been an increasing number of actively managed ETFs that seek to primarily invest in instruments that raise concerns with respect to liquidity and transparency, including emerging market debt securities, high-yield debt securities, and other instruments.”

Despite the concern, such synthetic pools are a small proportion of U.S. ETF/ETP market, she notes: only 3%. By contrast, they have a 10% share in Europe.

Then again, the concern is very real.  “[B]ecause ETF share prices are dynamically linked to the prices of their underlying holdings, the trading and other characteristics of the underlying portfolio investments, such as certain illiquid types of securities and particular over-the-counter or ‘OTC’ derivatives, may impact the arbitrage process necessary to closely align the ETF share price with its NAV. In certain circumstances, temporary imbalances in supply and demand might result in the price of the ETF decoupling from the value of the ETF’s underlying instruments as the ETF starts to behave more like a stand-alone product whose price responds solely to whatever liquidity is immediately available in that product, regardless of the value of the underlying investments. Under these circumstances, the ETF can begin to trade at a significant premium or discount to the NAV of its assets.”

That’s a theme close to the heart of Harold Bradley, Chief Investment Officer of the Ewing Marion Kauffman Foundation.

“We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses.  When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around. This tendency is especially pronounced for ETFs that are comprised of small cap stocks or stocks of newly listed companies, that generally are thinly traded.”

In his view, this leads to ever more reliance on untransparently priced derivatives.

“High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time. … Consequently, market makers can often only match their positions against futures, options or other ETFs, or they must employ derivatives and synthetic securities.”

The result is greater volatility. Are there solutions? Noel Archard, Managing Director at iShares, the biggest provider of ETFs (now owned by BlackRock) draws a line in the sand:

“While the first ETFs were straightforward, tracking relatively broad benchmarks such as the S&P 500 or individual country indexes, today some sponsors have introduced new products of increased complexity that carry greater risk and may not be appropriate for retail ‘buy and hold’ investors. Products which raise such concerns include so-called leveraged and inverse funds … products that are backed principally by derivatives rather than physical holdings.  These products require a greater  deal of disclosure and up-front work with clients for them to understand investment and structural risks and BlackRock believes that they should not be labeled ETFs.”

The gauntlet has been thrown. Next post: a perspective from Europe, where synthetic ETFs have a much larger market share.

Thus Occupy Wall Street protestors decried banks that had been bailed out, yet still handed out lavish bonuses to their own employees. This, for them, was evidence of neo-liberalism and financialisation, which guts the truly productive economy in favour of speculation.

More latterly, the Tea Party has warmed up to the theme: private equity makes money by firing workers. At least that’s what one might assume from a recent political video disparaging Republican candidate Mitt Romney, once a prominent leveraged buyout specialist, now the Snidely Whiplash-like  King of Bain.

Which leads to an obvious question: do financial services create value? Certainly the academic wisdom has come under fire. In the two decades leading to the Great Recession, academics had mostly converged on Schumpeter’s view that well-developed financial systems play a crucial role in stimulating economic growth. … In fact, the body of empirical evidence linking causally and positively the depth of financial markets to growth was growing so rapidly that in 2003, in a discussion of a survey on the subject, one author was prompted to conclude that “…In 1993 many people doubted that there was a relation between finance and growth; now very few do.”

That’s from a paper, “On the tradeoff between growth and stability: The role of financial markets,” written for the VoxEu website by Alexander Popov and Frank Smets at the European Central Bank. It’s one of a series of papers VoxEu has published.

The absence of financial intermediation certainly has an impact and is, perhaps, key in the prolongation  of the slump.

“At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly,” note Andrew G. Haldane and Vasileios Madouros at the Bank of England.

“But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts …”

Explains Christina Wang, an economist at the Federal Reserve Bank of Boston:  “In particular, how much of the income received by financial institutions is compensation for actual services provided to their customers and how much is merely for taking on risk, such as funding risky loans with short-term borrowing?”

The former is valuable; the latter a passive activity whose profits stem from leverage. But, she says, it is hard to separate the two activities.

“This is primarily because they often do not charge explicitly for services. Instead, they earn a spread between the interest rates received and the rates paid, as well as fees for writing derivatives contracts such as options and swaps. But earning interest is not in and of itself a productive activity that contributes to GDP. This is obviously sensible in the case of passive investors who buy market securities and then merely receive interest or dividends without producing new goods or services.”

Instead, she argues that ‘[t]he basic logic of the method for inferring the value added of bank services is intuitive. First, consider cases where a bank performs a transaction that earns it interest or fees, such as making a loan or underwriting a derivatives contract. We can ascertain what the bank would have to pay (in terms of either interest or fees) to purchase in the market a financial instrument of the same risk characteristics. Subtracting the value of, or interest on, the comparable market security from total income allows one to infer the implicit revenue the bank earns for services above and beyond investing passively in market securities. An analogous adjustment applies for transactions on which banks pay rather than receive interest or fees, such as those related to depositors.”

As a result she concludes that, “[m]aking conservative assumptions, we show that the current official method overestimates the service output of the commercial banking industry by at least 21% (amounting to $116.8 billion in 2007:Q4 for example) and GDP by 0.3% ($52.9 billion in 2007:Q4 for example) between 1997 and 2007.”

Outside the U.S., Haldane and Madouros come to a similar conclusion.

“The headline national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War. At face value, these trends would be consistent with large productivity gains in finance.”

In fact, however, the productivity gains seem illusory.

“But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

“In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance.”

More intriguingly, adds Thomas Phillippon, a professor at the Stern School of Business in New York:

“The cost of intermediation in the US is between 1.3% and 2.3% over 130 years. However, the finance cost index has been trending upward, especially since the 1970s. This is counter-intuitive. If anything, the technological development of the past 40 years – in IT in particular – should have disproportionately increased efficiency in the finance industry. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?”

His answer: excessive trading, as a result of which “the finance industry’s share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the US alone. “

There’s only one glitch. An enhanced CPP will do little for for boomers nearing retirement – though it might instill a little fiscal discipline in their children. As would broad-based pension reform. So why the focus on CPP? Because the alternative, voluntary savings through RRSPs or the proposed Pooled Registered Pension Plan (PRPP), won’t do the trick either.

As the Canadian Centre for Policy Alternatives reports, in a paper written by independent pension expert Monica Townson: “what will be offered is not a ‘pension plan’ but a savings scheme.”

All quite true. But it raises questions in the retirement income debate that very few are deeply considering. The first question concerns the nature of retirement savings: should they be compulsory or voluntary. The second is whether they should come with a guarantee. These are both important questions – but they come too late for near-retiring boomers .

So how do we make it right for the next generation? Make voluntary savings compulsory? Or extend the compulsory savings system? In other words, more registered plans, or more CPP.

But first, we have to consider who has to be forced to save. It’s not the poor, nor even half the work force. Keith Ambachtsheer suggests exempting those making more than $30,000 from any new compulsory pension scheme,  in a paper he has jointly written with former Ontario Securities Commission chair Ed Waitzer.

The reasoning isn’t hard to follow. First, the median income of Canadian taxfilers is $25,000. Half the working population, more or less, receives an adequate income replacement, through a combination  of state pensions (OAS and GIS) plus forced savings (CPP).

As for the rich, that’s a somewhat subjective estimate, but the top income decile starts at $64,000. Those are the people who, if they don’t have registered pension plans, are socking away money in RRSPs and Tax-Free Savings Accounts, that is, if they’re not playing grasshopper.

Indeed, Townson highlights that point: “Very few take advantage of RRSPs and a recent survey from Ing Direct noted that only 41% of Canadians have a TFSA and almost half of those earn $100,000 a year or more. Only 24% of those surveyed said they used the TFSA for retirement savings.” The implication is that the rich can look after themselves.

But apparently, the middle either can’t or won’t. Hence Townson’s comment: “The proposed PRPPs simply offer yet another voluntary savings vehicle that will not guarantee any particular pension at all.”

The federal government’s Pooled Registered Pension Plans, legislation for which was approved in November, does indeed have flaws, most of them relating to the voluntary nature of participation. Ambachtsheer and Waitzer enumerate three:

– Voluntary employer PRPP participation, as envisioned in the bill, will result in minimal actual PRPP uptake.

– Bill C-25, in its current form, is virtually silent on the important questions of PRPP default option design, which most participants would either choose or default into.

– Saying PRPPs should be “low cost” and leaving PRPP regulation to current, cumbersome regulatory processes would not directly address potential conflicts of interest and informational asymmetry between enrolled workers and PRPP administrators.

They would prefer a structure that mandates employer participation, with perhaps a tax credit for offering the plan. They also suggest a mandatory contribution rate of 10% as the default option (even though that is lower than the 18% maximum for RPP or RRSP savings), preferably split between employer and employee. Finally, to escape the federal-provincial conflicts that bedevil such things as the establishment of a national securities regulator, they suggest a joint regulatory body to supervise PRPP administrators. But these decisions, all three, will  have to be made province-by-province.

Is that a good enough fix? Not suggests Townson. “Since very few people take advantage of existing voluntary retirement savings schemes, it is not clear why officials are claiming the proposed PRPPs will prove more attractive than the existing programs. So far, the only advantage being promoted for PRPPs is that management fees will be lower than for individual RRSPs, since contributions will be pooled. But, of course, there is no guarantee of lower fees, nor is there any certainty that this would be a big selling point for the plans. It’s also worth noting that there is no evidence people are not saving through RRSPs because of high management fees.”

The alternative is an expanded CPP, since it is both compulsory and provides a guaranteed income. But only if it is pre-funded, as Townson notes.

“CPP legislation now requires that any change/increase in benefits be fully funded in advance. A doubling of benefits would therefore mean that contribution rates would have to be increased to fund the benefits. The Canadian Labour Congress proposal suggests phasing in the required contribution increase over a period of seven years. But it would take 40 years for these increases to provide full funding for a doubling of benefits. However, benefits could be increased gradually during the phase-in period so contributors would be able to get gradual increases in their pensions.”

With pension reform, it’s six of one and half a dozen of the other. There is no quick fix. The only question is whether people save more by carrots or sticks – and we have yet to enter that debate.

Bfinance, a London-based consultancy for institutional investors that specializes in private equity, reported recently that 90% of investors expect more than a 10% internal rate of return on private equity.

Unfortunately, this expectation flies in the face of the (historical) facts. Notes bfinance: “To achieve their objectives, investors would probably have to devote the very greatest care in selecting their managers and would need to actively manage their investments. In fact, according to the Preqin statistics on a sample of 1,906 funds launched since 1980, the median return from private equity expressed in terms of net Internal Rate of Return (IRR) came out at 9.5%. In other words, less than half of Private Equity funds generated an IRR higher than 10%, as hoped for by nine institutional investors out of ten.”

That isn’t to say that private equity investments can’t be worthwhile. Indeed, there are a number of reasons to try to tap private equity returns: to enhance portfolio returns, to get access to other, non-public, sources of returns and to reduce volatility. “Private equity’s historical median performance, all strategies taken together, is still respectable given the current outlook for returns offered by other asset classes held within institutional portfolios,“ bfinance reports.

That’s the objective. The favoured means to carry it out is problematic.  “In selecting their managers, investors place most importance on the quality of the private equity firm’s investor base and reputation. These two criteria are of the sort that encourages herd mentality. However, from experience, channelling too much new investment money to a single manager or to a given strategy generally results in a lower level of returns.” While funds of funds have a smaller footprint, there is still a reliance on direct funds, and indeed, a reliance on general partners, particularly in reporting returns. Larger investors, however, do seek out third parties for due diligence.

One consequence, bfinance reports, is that instead of holding for the long term, with a manager who is skilled at shifting investments, smaller investors simply “vote with their feet” and chase performance.

Private equity commitments not yet called, bfinance notes, are now up to  $900 billion. That’s a lot of money waiting to depress returns.

So how can one avoid following the crowd? Bfinance suggests that venture capital performs well below expectations, while LBOs seem to meet expectations. Private debt, however, seems under-regarded, despite its volatility-dampening characteristics.

“For investors who invest in private equity opportunistically,” bfinance writes, “the expectation of significantly lower returns from these debt/mezzanine strategies deserves to be re-examined from the angle of lower dispersion in performance: 800 basis points between the net IRR of top quartile funds and third quartile funds (for a median return of 8.8%), against a range of over 2,000 points for venture capital strategies (median return of 6.4%) and a range of 1,800 points for special situations (median return of 13.6%).”

The risk/reward expectation surfaces in another one of bfinance’s analyses. Thus, in a separate report on infrastructure investing, it notes:

“While Canadian, Australian and Korean pension funds and sovereign wealth funds buy stakes in UK airports and water companies, UK pension funds’ exposure to the asset class is less than 1%, compared with 8-15% in Australia and Canada. Consultants attribute this to UK pension funds’ risk aversion and dislike of leverage, inexperience in striking such deals, lack of resources to manage large infrastructure assets and the disappointing returns in 2007-09.“

Again, this may be attributed to overly high expectations before the financial crisis, this time tamed by disappointment.

“Infrastructure is a broad term, encompassing many different types of assets and deal structures. It can be accessed through bonds, private debt or private equity. On the private equity side, if cash-flows are availability-based (and assuming the sovereign counterparty is sound) rather than user-pay, held for the long term and prudently leveraged, then one might argue its position as a bond substitute,” says Vikram Aggarwal, Director, Private Markets at bfinance. “However, in general, infrastructure funds often behave in the opposite way, by holding assets for relatively short time periods, using a lot of leverage which is often in the form of short term borrowings, leaving it vulnerable to re-financing issues and real risk of capital loss.”

The message, it seems, is know your asset class – and your horizon.

The Canada Pension Plan Investment Board is now in the second version of its reference portfolio in the past five years says John Ilkiw, currently an independent consultant and a former senior vice-president CPPIB. Established in 1997, its initial objective was a 65%-equity/35%-bond split, and as a start-up, CPPIB invested passively.

He made his remarks this month at a presentation on portfolio benchmarks sponsored by the Canadian chapter of the Alternative Investment Management Association (AIMA) in Toronto.

CPPIB’s strategies – indeed, its investment objectives — have changed over the years, hence the need for a reference portfolio. The portfolio breaks out asset categories, and provides a low-cost, all-index and broadly diversified allocation that seeks to capture systematic risk – or the market return. But the reference portfolio is not the actual investment portfolio.

CPPIB’s board determines the reference portfolio; its active managers have broad flexibility in implementing it. The idea is to relieve the board of getting into highly complex investment structures they weren’t expected to understand but nevertheless had to approve. In addition, the reference portfolio sets out the active risk measures; thus the investment managers have a annualized risk measure of 90% Value at Risk – meaning normally no more than a 10% drawdown. (“Normally” is a freighted word, however, that hides more than it discloses when it comes to financial markets under duress.) The only time the board is involved in daily investment decisions is when they concern very large transactions, or when they might jeopardize CPPIB’s reputation.

The reference portfolio provides a benchmark that is “easy to understand, easy to explain and easy to measure,” Ilkiw explains. It also frees the hand of investment managers. The current reference portfolio is 45% foreign developed market equities, 25% Canadian nominal fixed income, 15% Canadian equities, 5% Canadian real return bonds, 5% emerging market equities, and 5% foreign sovereign bonds.

What the investment managers add are two things. The first is the “better beta” component, namely asset classes that are not yet amenable to being passively indexed, for example private equity or real estate. Then there is the quest for “incremental risk-adjusted returns” through active management. Often, says Ilkiw, these two cannot be separated and he cites private equity investing as an example: leverage and alpha both contribute to returns.

But that creates a risk to be managed. CPPIB runs a “giant long/short portfolio,” Ilkiw adds. Since private equity is still equity, to add 10% exposure (CPPIB is currently running exposure at 15%), CPPIB would have to sell off 10% of its public equities to stay within the reference portfolio.

But it’s more complex than that, since private equity is normally leveraged by about a third. Thus, to be risk neutral, a further portion of the public equity portfolio is sold to fund the fixed income portfolio to keep the effective equity exposure constant.

When it comes to judging investment success, Ilkiw suggests a two-by-two matrix with two variables: market risk and active risk. If markets perform as expected, and if the active management program also performs, it’s a success — that’s the upper left-hand or northwest quadrant. But there are instances in the matrix where one or the other – or both – don’t perform. Market risk – Ilkiw labels that “an Act of God” — has not been rewarded lately, while active management has contributed 17bps to total portfolio returns. The matrix allows for accountability to the CPPIB board.

Like CPPIB, University of Toronto Asset Management has adopted a reference portfolio approach. Unlike, CPPIB, however, it is not a direct investor but rather a “manager of managers,” says Bill Moriarity, UTAM’s CEO. UTAM has almost 100 investment managers.

It has followed the U.S. endowment model, pioneered by Yale and Harvard. There are a couple of considerations behind that model. The first, given the general ebullience of equity markets plus declining inflation “you didn’t have to be a rocket scientist to generate great returns” in the 1980s and 1990s, Moriarity explains. But things changed after the bursting of the Technology-Media-Telecommunications bubble in 2000. Before that investors could count on a traditional 60/40 portfolio invested mostly in domestic stocks and bonds to deliver around 10% real return in the U.S. and 7% in Canada. Over the past decade, that traditional portfolio has delivered around 2.4%– much less than the 5% endowments need to sustain funding commitments and maintain purchasing power.

As a consequence, endowments have increasingly shifted to a “multi-asset diversified portfolio,” which downplays domestic securities in favour of foreign and private market ones, and moreover, overweights equities in virtue of their potential contribution to funds that exist as perpetual pools of assets.

But once one moves beyond traditional domestic assets, a strong investment infrastructure is required, he says. And, a more sophisticated staff understanding of how asset allocation works. Indeed, 2008 proved tumultuous for UTAM. “It’s no secret that the University of Toronto had a difficult time in 2008.” He attributes that to a focus on asset class returns rather than the underlying risks of the portfolio. UofT wasn’t alone: many portfolios were “well-positioned for normal times, but not for times of substantial stress.” But UofT also had many private equity investments where it had neither the scale to get lower fees, nor the expertise to evaluate the risks, Moriarity says. “We just didn’t have the resources to invest effectively.”

As it turned out, many apparently different asset classes – hedge funds and private equity — shared common underlying return drivers with other elements of the portfolio, and that has led to a different approach at UTAM. The first was the adoption of a reference portfolio, meant to be a “shadow portfolio” that would be appropriate to a university endowment. That resulted in a asset allocation of 30% to U.S. equities, 15% Canadian, 15% EAFE, 35% fixed income and 5%  real return bonds, with currency 50% hedged.

The second was to divide exposures into five different risk buckets: economic growth, credit risk, interest rate risk, inflation risk and currency risk.

But that’s not a paint-by-numbers approach, Moriarity says. He points out that Harvard and Yale, following a similar endowment model, have very different actual asset allocations. Instead, the reference portfolio is a process that has a “fourfold benefit:” better understanding of the return drivers; better understanding of how the portfolio is likely to perform; a better basis for portfolio discussion;and a better understanding of potential stresses.

That eventuates in “better beta,” as a “more granular approach to risk metrics” helps educate stakeholders who, on a behavioural basis, tend to be pro-cyclical.

And that, he feels is necessary to get beyond what is on offer in the market: a 2.5% real return.

Still, despite years of CAPM, Arbitrage Pricing Theory, Black-Scholes, Gordon dividend-growth models and other tools of the trade, the crowds – the punters – apparently are open to less theoretical approaches.

They probably always were. But now Ladbrokes, the venerable London betting shop, is offering bettors the ability to gamble on the closing price of the TSX, exchange rates and even individual companies. Sounds like an actively managed ETF; or a futures market. Looks like one too but for the absence of continuous trading. The bet, once made, sticks, despite ticks in market price. It’s a market order that may or may not be filled, but one with a built-in stop loss.

Naturally, regulators seem concerned. Not that bettors may not have a proper prospectus. Nor that best bid-offer rules are not being followed. But that insider trading might arise. As quoted in The Toronto Star,

“It’s not just the size of the market which could tweak the OSC’s attention though. The wagering also raises the possibility of company insiders manipulating their company’s share price to make their gamble pay off, says Kelley McKinnon, a partner and securities litigator at Gowlings law firm.

“’Regulators care if someone manipulates stock prices for their own benefit. Manipulation is an offence. While gambling enterprises wouldn’t be in (the OSC’s) jurisdiction, regulators would likely investigate someone manipulating stock prices in order to win their bet,’ said McKinnon, the OSC’s former deputy director of enforcement, and a current member of the OSC’s Enforcement Advisory Committee.

“’Canadian securities regulations dictate that company insiders must report any holdings in company stock or ‘related financial instruments,’ according to the OSC’s website. That makes the Ladbrokes wagers a security, which the OSC in theory can regulate, says Ed Waitzer, a partner at Stikeman Elliott law firm, and former OSC chair.

“’Is it a security? Probably. The case law basically says a security is anything where the value is related to the performance of the entity in some way,’ said Waitzer.”

No point in laying odds on that one, not if regulation extends only to registered market participants rather than owners of off-track betting saloons.

Still, that may be a diversification option for money managers. Why not cover all the bases when it comes to risk assets: ponies and portfolios, OTC and OTB, large-caps and lottos?

Some Connecticut asset management executives seem to have done just that, though perhaps without too much thought. They grossed $254 million on a $1 Powerball lotto bet.

“’The lottery is all about dreaming, and that runs across all demographics and all people,’ said Anne Noble, the Connecticut lottery’s chief executive.”

While their firm, Belpointe Assset Management, does co-invest in alternative assets, there’s no evidence that lottos are in the investment menu. But co-investing, apparently, is, according to The New York Times:

“The three men made — or rather, multiplied — their fortunes with a single $1 ticket purchased at a gas station in nearby Stamford, a Connecticut lottery spokeswoman said. …

“The following day, when the results were announced, the co-workers realized they had won a lottery with odds – 1 in 195,249,054, to be specific – that would make even the boldest hedge fund manager run for the hills.”

New meaning for black swan investing: a dollar here, a dollar there, these small but regular losses might amount to something. Then again, most probably they won’t … no more than rolling up the rim at the local TimBits equivalent will.

The result: small pension funds are uncompetitive, suggested Canadian pension expert Keith Ambachtsheer, who gave the annual FairPensions lecture last week in London, England. FairPensions is a British NGO oriented to socially responsible investing.

In his lecture, according to Investment and Pensions Europe, he argued

“You need scale to be successful in this business,” he said. “You need large-scale pension delivery organisations. We need compensation schemes inside those organisations that allow those organisations to be competitive on the people-side.”

He argued that, even if an internal investment team each demanded a hypothetical salary of $1m, if this brought down overall external asset management costs, it was worth considering.

More interestingly, the private equity efforts of some Canadian plan sponsors were saluted, according to IPE.

Responding to Ambachtsheer’s lecture, Mark Fawcett, chief investment officer at NEST, agreed with many of the points raised, saying it was in his scheme’s DNA to be a long-term investor.

He also said that much could be learned from the investment approach taken by Canadian pension funds and cited Ontario Municipal Employees Retirement System’s joint ownership of the Channel Tunnel rail link with Ontario Teachers’ Pension Plan.

“As a result of having it in-house, they benefit fully from the growth of those investments,” he said, adding that this allowed them to “capture all that value in-house”.

Evidently, that raised the question of too big to fail. And certainly big pension plans can have a greater impact in the economy than small ones. As IPE reported:

Challenged by Bill Galvin, chief executive of the UK Pensions Regulator, on the question of whether the creation of these large-scale vehicles did not risk creating a small number of larger schemes that would then lead to systemic risk, Ambachtsheer countered that this could be avoided by having a clear set of rules to ensure each pension organisation delivered on its promises.

“Another thing to keep in mind: If you play this strictly inside your own country, you are missing a huge competitive advantage,” he said.

“You should be benchmarking yourself against the best in the world. The best in the world are organisations that seem to be in the order of magnitude of $100bn (€74bn) and 250,000 to 300,000 members.”

What’s interesting is that Ontario has proposed allowing smaller pension plans to have bigger ones manager their assets. More than that, some smaller pension plans have formed investment circles to be able to co-invest with the big players in infrastructure and private equity deals.

As Professional Pensions reported on Ambachtsheer’s lecture, the debate between DB and DC is stale. What counts is this:

• Aligned interests with pension plan participants
• Strong governance
• Sensible investment beliefs
• Right-scaled
• Competitive compensation

…

Ambachtsheer added: “Without the existence and legitimacy of highly-focused, well-managed long horizon return maximization instruments, pension funds cannot play the wise intergenerational investor role that we have cast them in.”

So what about corporations, whose “greed” has also been highlighted by the Occupy movements? It is unclear what greed could mean. If it means high salaries and bonuses for corporate executives, than that belongs properly to the personal income system. Even so, there is a danger in relying on high incomes, since the level of bonuses and capital gains depends on the state of the economy, as some U.S. states are learning to their regret. The top 1% of the income distribution does not have a stable earnings profile. It’s flush in good times, but ebbs like the Bay of Fundy in bad times.

As the Wall Street Journal notes:

“Nearly half of California’s income taxes before the recession came from the top 1% of earners: households that took in more than $490,000 a year. High earners, it turns out, have especially volatile incomes—their earnings fell by more than twice as much as the rest of the population’s during the recession. When they crashed, they took California’s finances down with them.”

But what about corporations themselves? After all, they are the ones that richly reward some, whether through bonuses, stock options or capital gains. What’s more, they appear to be sitting on vast hoards of cash that they are not spending to create jobs.

There are three issues here. The money corporations are sitting on has already been taxed once. To tax it twice would be akin to taxing everyone’s bank account, just because the money is there. It has been  done before, however.

Secondly, the cash hoard is not a sign of greed, but of economic fear – just as the cash building up in personal bank accounts is. It’s Keynes’s paradox of thrift. In other words, corporations aren’t spending because there’s no profit. Indeed, in the financial sector, one wag recently referred to Bank of America as a non-profit. But even for manufacturing enterprises, there’s little point in expanding production if there is already overcapacity. To put this in graphic terms, at the height of the U.S. auto boom in the mid 2000s, 18 million units were shipped. In the “new normal,” annual sales are hovering around 12 million.

Still, many corporations are profitable, including the once woe-begone automakers (now that their toxic liabilities have been shifted into windup corporations). And the news that GE did not pay U.S. income taxes last year sounds like the height of gall, with $5.1 billion in U.S. profits yet a $3.2 billion tax refund in 2010.

But this – the third point — illustrates the problem handily. A tax rate is one thing. Tax collected is another. Indeed, in Canada progressives like to point out that there’s no need for corporate income tax cuts, since the rates in the U.S. are much higher. But no one pays the posted rate in the U.S.

Higher rates in Canada, in any case, won’t yield much, if anything at all, Laval University economic professor Stephen Gordon thinks: “Profits are a very volatile series and are also highly cyclical, so there’s no reason to expect a tight link between short-term changes in CIT rates and movements in CIT revenues. But if you were making policy based on an assumption that CIT revenues were proportional to CIT tax rates, then you might want to see some sort of downward trend during a thirty-year period in which CIT rates were reduced by half.”

That didn’t happen. In other words, posted corporate income tax rates are poor predictors of revenue yield. More than that, they are not the major source of government revenues, though they certainly help. Since the 1960s, the bulk of federal tax money has come from personal income taxes and sales taxes – 60% or more of the total, while the corporate income tax share has varied wildly, from 18% to 6%. It’s currently 13%.

In Canada, there’s seems to be general acceptance, federally and provincially, about lowering corporate tax rates to around 25%. Interestingly, it looks as if the U.S. is also about to embark on this path.

Writes National Public Radio reporter Adam Davidson: “Most people who study the issue agree that the top federal corporate tax rate (35 percent of profits) is simply too high. …While this may seem like Republican propaganda, NPR’s “Planet Money,” for which I work, polled many leading progressive policy groups and academics, all of whom told us that they would support lowering the top corporate tax rate.”

But, he adds, “Even if we eliminated all corporate taxes, the extra $250 billion per year at the companies’ disposal wouldn’t be enough to make our $14 trillion economy grow. President Obama tried an $800 billion stimulus, and we’re still debating whether it helped or hurt or did nothing at all.”

That is the fundamental conundrum. The assumption is that corporations could hire, if tax rates were lower. But they’re not. Corporate taxes are, at best a sideshow.

An illustration: the U.S. taxes world-wide income, one consequence of which is that U.S. corporations keep their overseas earnings overseas, where they have already been taxed once. Many are proposing a tax holiday, so those funds would flow to the U.S. The last time foreign earnings were repatriated, it had little impact on job creation. More to the point, as Reuters notes, a large part of those foreign earnings are parked in U.S. Treasuries – even corporations these days are risk-averse. What happens if they bring that money onshore?

“Not all would be repatriated, and not all is held in Treasuries. But if even three-quarters of the total is invested in United States government debt, that would amount to $1 trillion — more than Japan’s holding of Treasuries, and almost as much as China’s.”

A Treasury sell off whose impact would be greater than a further downgrade of the U.S.’s credit rating? As the adage goes, be careful what you wish for.

To be sure, wealth is more concentrated and incomes are more polarized than since the 1920s. Is there anything public policy can do about that? Most millionaires receive their income in the form of wages and bonuses. Their compensation levels are governed by corporate boards of directors.
Wealth is harder to get a handle on, because it may be held in the form of shares or real estate or art. None has a stable value. If there is a tax-forced liquidation – or as we’ve seem from time to time, a market correction — the value of that wealth will likely be heavily discounted as too many distressed sellers seek too few willing buyers – unless the state steps in to stabilize wealth. Probably not what the occupiers were thinking.

So what does tax the rich mean? Equalize incomes? Or go where the money is? Equalize incomes sounds catchy, but not even Karl Marx believed in that. Some people will need more, and others less, to maintain a decent and equitable standard of living — not an equal one. Still, it’s an important point.

Arguably, the great equalizer since the 1920s has been the welfare state, in a twofold sense. The first is in making services such as education and health care available regardless of income. The second is in supplementing low incomes with transfer payments (unemployment insurance, state pensions, welfare, refundable tax credits).

Who pays for that? That would seem to be the real issue, given that Europe is in the throes of austerity and the curtain on that drama is about to be raised in the U.S.

Both the European and American middle classes claim to be tapped out. So tax the rich seems to mean “go where the money is.”This is where the wisdom of crowds turns into folly. Even if the 1% do pay more – which may not be such a bad idea – it won’t be enough to pay down deficits. That’s not an ethical judgment; it’s a mathematical one.

What does the data look like? In Canada, it is the middle class that has seen stagnant income growth, not the poor, writes Wilfred Laurier University economist Tammy Schirle in a cheeky blog called “’We are the 30%’ a better chant for protestors.” One observation from her data is that higher education rates have boosted income for women, and thus for many families — arguably a function of the welfare state. The analysis does not treat the tax-transfer system however. Still, as corroboration, Stats Can notes that the role of the tax-transfer system remains effectively unchanged; rising income disparities are not the consequence of social service cutbacks, but can be attributed, at least in part, to the rise of highly educated dual-income families.

It would appear the welfare state is working more or less as it should.

So who’s paying for it? According to another Stats Can study, the richest 10% paid 52.6% of federal income taxes, while their share of income was only 35.7%, as of 2002. Of course their income share had grown — perhaps because of their returns on education. The bottom 50% was paying 4.4%, a share that had declined by a third from 1990, even though their share of income had risen to 16.9% For the middle income group (“We are the 40%), their share of tax was  43%, though their share of income was  47.4%.

It seems the rich are paying more than their share. But, are they paying their fair share? As it turns out, the tax system is progressive, the Stats Can study notes. “In 2002, the 10% of taxpayers with the highest incomes paid an average of $16.47 for each $100 of income. On the other hand the one-half of taxpayers with the lowest incomes paid $2.89, a difference of $13.58. The group of intermediate-income earners fell between these two groups, paying on average $10.14 dollars for each $100 of income.” In fact, the 40% have seen their effective tax rate fall the most.

What may give readers pause is that the top 10% of the income distribution – the rich — starts at $64,500. Modestly well off, yes, but rich? Only compared to the median individual, with an income of $23,000.

But what about the 1%. Who are they? In Canada, the threshold is surprisingly low: $169,000, which accounts for 246,000 taxfilers, according to Armine Yalnizyan, at the Canadian Centre for Policy Alternatives. The income share of the top 10% she estimates at 42.5%; that of the top 1%, 15.7%

Their effective tax rates are roughly the same, around 30%, though the spread was much higher in the late 1940s: for the top 1%, rates were over 40%, while the top 10% paid around 25%.

Still, tax rates tell us little about the taxes that could be paid. In CCPA’s Alternative Budget, we do get an idea, however,. First, it estimates the cumulative cost of federal tax cuts since 2006 at $35.3 billion (just over one-third of which comes from GST reductions and an equivalent from broad-based personal income tax reductions). But the alternative budget does not suggest rolling back those tax cuts.Instead, it recommends a new tax bracket at 32% for those making $250,000 – most of the 1%. Expected yield is $2 billion. Then it adds a new tax bracket at the $750,000 level at 35%, yielding $1.2 billion. Sounds like a lot of money.

Except the total take from federal personal income taxes is $120 billion. So taxing the rich, while sexy in concept, is pretty much a wash in reality: a 2.5% solution for the 1%, and even more diluted against total federal revenues.

Is Canada a singular case where the rich are less than they seem? Not according to Adam Davidson, a reporter at National Public Radio in the U.S.

“It’s tempting to look to our millionaires and demand they pay more in taxes, but the same inconvenient truth applies. When you add up all the money made by all the people who earn more than $1 million a year, it amounts to around $700 billion. But since the millionaires already pay close to $200 billion in taxes, the government would have to increase rates to nearly 100 percent — which is about the worst idea ever — for it to have any real impact.”

What Davidson is referring to is a $400 billion annual gap between U.S. federal revenues and expenditures.

“It serves the interest of both parties to argue about taxes on corporations and the wealthy because neither wants to discuss the alternative, which is where things get touchy. To solve our debt problems, we have to go to where the money is — the middle class. People who earn between $30,000 and $200,000 a year make a total of around $5 trillion and pay less than 10 percent of that in taxes (owing mostly to tax incentives and the fact that most families make less than $68,000, where larger tax rates begin).  Increasing the middle-class tax burden an additional 8 percent, however, would actually have a bigger impact than taxing millionaires at 100 percent.”

To pare the deficit, the middle class – the 40-percenters — will have to pay because, to paraphrase bank robber Willie Sutton, that’s where the money is. Or is it the corporations? Watch for Part ll.

To be sure, Canada’s economic performance has been better than that of the U.S. since the onset of the Great Recession. Growth is higher, unemployment is lower, the housing market appears to be healthy. But that doesn’t mean Canada isn’t suffering through a post-recession hangover.

It’s just this time, it’s much weaker than the 1991-1992 or 1981-92 hangovers. Those times, we had to depend on the American consumer to buy our cars and timber. This time around, they’re not buying. They’re tapped out. But others are buying our oil and wheat

So why complain? Because, well, our banks weren’t virginal to the financial instruments that amplified the global financial crisis. The common view is that they were at least prudent in their counterparty relationships. Yet, many protestors and commentators put Canadian banks in the same financial policing lineups as the usual suspects: promiscuous U.S. thrifts and U.K. building societies, with such trustworthy names as Northern Rock or Washington Mutual.

Why the clamour against Canadian banks? Because the federal government, through the Canadian Mortgage and Housing Corporation, offered to trade the banks up to $125 billion in mortgage debt for  safe Canadian T-bills during the height of the financial crisis.

“Bailout,” both Bay Street and activists cried. Liquidity injection, the bankers retorted.

Said Murray Dobbin at Rabble.ca: “But call it what you will — the Canadian government borrowed and spent billions to backstop the banks lending during the recession and continues to do so. That borrowing is a cost to the taxpayer and many of the mortgages they bought up (starting with $75 billion in the fall of 2008 and then adding another $50 billion a few months later) could still go into default. If they do the taxpayer is still on the hook — not through the government but through the CMHC, a government backstopped crown corporation that had to be rescued by the taxpayer before.”

Wrote Mark McQueen, who runs private equity at Wellington Financial: “The federal government created a unique program through CMHC specifically targeted at allowing Canadian chartered banks to move tens of billions of dollars of assets off of their balance sheets. The reason? Canadian banks couldn’t raise sufficient and/or cost-effective funding from their traditional sources – primarily other global financial institutions – and needed Crown intervention to keep the wolf from the door. …

“There is only a subtle distinction between injecting capital into a bank and relieving it of assets so that it can avoid a capital injection. Kind of like your Dad temporarily buying your bike from you when you ran out on money in University, and then selling it back to you six months later when you were flush from a summer job. The notion that Canada’s ‘free market’ took care of itself over the past 15 months is poppycock.”

On the opposing side was Nancy Hughes Anthony, then head of the Canadian Banker’s Association. “Unlike other countries, not one bank in Canada went bankrupt or required a cent in taxpayer-funded bailouts.  The government of Canada bought insured mortgages from the banks when the global credit markets seized up to ensure that credit continued to flow to consumers and Canadian businesses. The government will make a profit on these transactions and it should be noted that these mortgages were already insured by the CMHC and therefore, create no additional risk for the government. “

So was it a bailout? In the U.S., the Treasury took toxic assets off the hands of the banks, much as the Resolution Trust Corporation took on the assets turned liabilities of the failing Savings and Loans even before the1991-92 recession. So taxpayers took a loss, lest the banking system collapse. Or the auto industry.

Did CMHC take toxic assets off the Canadian banks’ hands? (With the prices people are willing to pay for houses, surely there must be a lot out there.) Apparently not. Canadians are dutifully paying their mortgages, at least under the current low-interest rate regime (It probably helps that most Canadian mortgages are full-recourse: you can’t just hand in the keys and walk away on your flippers if you’re underwater.)

In the end, the Canadian banks only availed themselves of $69 billion in the IMPP facility, according to CHMC. And it turns out the federal government made a 1% profit.

How’s that? The Insured Mortgage Purchase Program involved the banks selling to CHMC pools of mortgages that CHMC had already insured. So there was no transfer of risk – or toxic assets. Yes, the Bank of Canada had to sell bonds  for CMHC to purchase those mortgage pools. But, in exchange for buying those mortgage pools, CHMC set a floor, through a reverse auction, so  that it would be compensated for its borrowing costs.

The result:  the banks offered somewhere between 86 and 100 basis points as their cost of (liquid) capital. Instead of paying Canadians to buy government debt at 50 basis points, CMHC was getting roughly 100 basis points for selling government debt. Not a bad deal, one would think, for buying assets where the risk of a long workout, as in the U.S., was minimal.

So no bailout. But was it economical? Did it increase liquidity? That’s hard to track, since the banks could have done anything they wanted with the dear money they had bought for loans that were already guaranteed, and for which the taxpayer was already on the hook, come what may.

According to Jean-François Nadeau, a Parliament of Canada researcher:

“It is true that there is no mechanism compelling the financial institutions to make the newly acquired cash available to households and businesses; they can use it for other purposes, such as improving their balance sheets. However, the data on available credit seem to indicate that the measure has helped financial institutions provide credit to households and businesses.

“In October, November and December 2008, the value of credit extended to households rose by $30 billion, including a $24 billion increase in mortgage credit. The figures on non-residential mortgages are less impressive: they show a rise of some $2.2 billion over the same period. Business credit as a whole rose $20.6 billion. In the fourth quarter of 2008, the combined increase was thus slightly more than $50 billion, twice as much as the value of the mortgages that CMHC purchased in its auctions in late December 2008.”

So it looks like debt-addicted Canadian consumers were bailed out, rather than the banks. The Canadian banks, unlike their American counterparts, weren’t knocking at the Grim Reaper’s door. They could have stopped lending for lack of funds. Or they could have passed on higher costs to consumers still seeking the ultimate “safe” return in leveraged real estate. The banks’ illiquidity could very well have become the consumers’ insolvency.

As the song goes: who’s bailing whom?